Hedging 101: Analogies and Assets

Looking to reduce investment risk exposure? Then you may have seen the word “hedging” in your research. Cassidy Clement, Senior Manager of SEO and Content at Interactive Brokers, is joined by Kevin Davitt, the Head of Index Options Content at Nasdaq. Together they discuss the general concepts and conversation points of using hedging to limit risks in investment of financial assets.

Contact Information:

indexoptions@nasdaq.com

Summary – IBKR Podcasts Ep. 106

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Cassidy Clement

Welcome back to IBKR podcasts. I’m Cassidy Clement, senior manager of SEO and content at Interactive Brokers. Today I’m your host for our podcast and our guest is Kevin Davitt, the Head of Index Options Content at NASDAQ. We’re going to discuss the basics of hedging. We’ll look at the general concepts and conversation points that are used in hedging that way to limit risks and investments of financial assets. Welcome to the program, Kevin.

Kevin Davitt

Thanks, Cassidy. I’m excited to be here and I’m looking forward to this specific topic.

Cassidy Clement

Awesome. So, because this is kind of a 101, can you explain a little bit to the listeners about a portfolio and then what is a hedge?

Kevin Davitt

Yeah, I think I can. And as you and your team are likely familiar, I’m a fan of analogies with interesting questions. And so, I’m going to start that way. I’m old enough to remember when music wasn’t all available at my fingertips with Spotify or some other streaming service. So, I think about my teenage self or my 20-year-old self and my idea of a portfolio then was like what CD’s make up your collection, what compact discs and I thought that said something about your taste. What’s important to you and what do you like? There are still people that collect albums, so LP’s, and maybe they would never sell their Beatles Revolver album. But there could be turnover in other albums, and I think about that similar to a portfolio. In that vein I will to this day look at when I go into somebody’s house, look at their bookshelves, and and get a sense of what they like to read, what authors they’re drawn to. So, this is my roundabout way of saying that a portfolio is a collection of assets. If you’re thinking about your investments, they are likely not all in a single underlying security, so that would be just like you don’t have one book or one compact disc. And you don’t listen to one musical act or one author; you diversify. So, in short, a portfolio is the whole collection of investments. Things that have value. Ideally, the value of those underlyings increases over time. Now, as you age something like a home may become your biggest single investment. Then you have retirement plans, perhaps a taxable account or investment account, and they’re all part of a much broader portfolio. Hopefully that made some sense or was it too esoteric?

Cassidy Clement

No, I mean that totally makes sense to me. I think it’s a really good analogy. Because when you think about it, there’s different genres, there are different types of music. Like you could be listening to something that’s a short intro, outro long version, radio edit. Totally makes sense to me, but when it comes to the main thing we’re covering, what’s a hedge?

Kevin Davitt

So, when you think about that portfolio at the broad level, we’re going to drill down into how you could theoretically protect those investments, that group of investments. And I tend to be a little bit Socratic in my approach. So, I’m going to answer that question a bit with a rhetorical question for the listeners. I’ll pose it this way. Why do you put on your seat belt? And I’ll pause for just a second. Like just think about that. Why do you put on your seat belt? Besides the potentially annoying noise that your car might make if your seat belt isn’t fastened, you likely do it because it can keep your whole body from going through the windshield in the case of a collision, or, in a worse situation, it can keep you alive. A hedge is a tool that’s designed to offset a pre-existing risk. And a seat belt is a hedge of sorts that we use often in capital markets. There are plenty of pre-existing price risks. Anytime you buy something you’ve exposed yourself to price risks generally. An underlying security or an index moving lower with some velocity is the sort of price shock that we’re referencing here. Now going back to our analogy on the highway, the pre-existing risk is speed and the possibility that you or someone else doesn’t stop in time and everyone is assuming that risk. Some choose to buckle up and offset some of that risk. Others don’t, and their exposure in the case of an adverse event is likely higher or worse. So, this is my roundabout way of saying that a hedge is a tool that should work in equal and opposite ways as the prevailing force. So, when we think about most investors, they tend to be what we call passive long the market. They, overtime, accumulate assets, they buy securities that they hope will appreciate. They put money into their 401K or that tax account. And they buy things that may be designed to track the performance of an index, like the NASDAQ 100. Granted, I work for NASDAQ, but there are huge amounts of assets designed to track that specific index. So, they’re positioned for markets to move higher, and their risk is a pullback. What can be most shocking is a sharp pullback. So, a situation like we saw in early 2020 with the pandemic and in the event of that situation a portfolio could lose 10% or 20% or more of its value quickly. And it’s a very real risk. So, the hedge is designed to offset some degree of that risk. If I think more broadly, the sequence of your returns in capital markets matters, and it matters a great deal as we age. So, arguably, having what I’ll refer to here is like a a portfolio seat belt. The importance of that generally grows as we near retirement age because our assets are likely bigger in total value than they were years prior. And we are more likely to rely on those assets sooner. So again, I went with an analogy, but in short, a hedge is any tool that is designed to offset a pre-existing price risk and it flows nicely into the consideration of options because that utility, specifically with put options, tends to be something that a lot of market participants use.

Cassidy Clement

So, you mentioned put options, so there’s going to be a lot of jargon if you’re having a conversation about hedging, it’s not one for those who just opened up their finance 101 textbook and got to chapter one, page one. So, what jargon is commonly used in these hedging conversations? You mentioned options and futures, could you discuss the the background of these?

Kevin Davitt

Yeah, I can. I have a friend who termed, I don’t know if it’s hers, but I love the term jargon monoxide and I think jargon monoxide exists in all lines of work. They’re sort of terms that we throw around that implies you’re part of it. You get it, but it can be very off putting to people that are newer or uninitiated in these terms, and generally speaking, they’re not that complex. So, when I think about hedging and derivatives in general, which includes both futures products and options, they are standardized tools that, throughout history, have been used to manage exposure and manage risk. They both have embedded leverage. I can explain that a bit better. They can be used to, for a variety of reasons, but having that potential to protect against an adverse outcome is very much one of the primary uses for either futures contracts or options. Now, they are derivatives in the sense that they derive their value from a reference asset in securities. A single equity option is dependent in large part on the value of the underlying cash equity. So, you could be thinking about Apple or Netflix or Nike or Tesla. It could also be an index. Now moving on and addressing some more of this jargon, it’s important to know that, broadly speaking, options that are purchased, or we might say long options, that’s interchangeable with something that I bought, convey rights but not obligations. That’s important, whereas short options or options that have been sold come with obligations to deliver either shares or cash. So, let’s cut through some of that jargon. Options are standardized. What that means is they’re fairly uniform in their construction. There have been some changes in recent years, but for the sake of simplicity, one option contract governs 100 shares, or units of the reference asset. That contract, like any other legal contract, has a cost. There is a term or duration. There’s a strike price; all of this legalize. And I don’t mean to insult anyone’s intelligence here, but the podcast, I think, is geared toward a more foundational audience. So, there are two types of options. There’s calls, and there’s puts. So, a purchased or a long call conveys the right, but not the obligation to buy 100 shares of the reference asset at a specific price on or before a specific date. And then if I purchased a put option that conveys the right to sell 100 shares of the reference asset at a specific price on or before a specific date assuming we’re talking about an American option as opposed to a European option. The only difference there is that a European option can only be exercised the expiration date. There was jargon there, but hopefully I addressed it somewhat. The other question you posed was on the futures side. So, futures are also derivative contracts. The difference in this case is that the reference asset in the futures market is often a commodity as opposed to an equity. So, there are futures contracts, things like crude oil, corn, wheat. We’re talking about tangible commodities. There are also spot or what the market refers to as cash markets for those products, and the futures contract relates to the cash market futures contract, whether it’s bought or sold involves an obligation. Futures are also standardized, but there is greater variation on the futures or commodity side of the business. What I mean there is that contract multipliers can differ from product to product in the futures market, whereas in the equity option market, a call or put almost always governs 100 shares. So, just a brief example, the multiplier for a standard crude oil futures contract would be 1000 barrels or 1000 multiplier. The contract multiplier for a standard corn or grain contract is 5000 bushels. If you think about, but somewhat less prominent markets like Arabica coffee futures, the multiplier there is 375. Now, there are reasons for the way those were standardized and they date back to, in some situations, 150-plus years, but you need to know what futures contract you’re trading and what the multiplier is. The same with options contracts, and the use cases again; gain exposure to an underlying market or to reduce or eliminate a pre-existing price risk. That hopefully was a decent primer. And again, if there are questions, I love opportunities coming on Interactive Brokers and if you have ideas about future programming, I welcome those.

Cassidy Clement

Yeah, I mean, you covered basically a majority of the things that are going on in these conversations, kind of the background of, hey, here’s the precursor to some of these vocab words that are going to be dropped. But the only other one that I know that I hear a lot is a covered call. So, that I learned about when I was studying for my Series 7. But if you can give some insight to our listeners on that topic.

Kevin Davitt

That is a term that’s thrown around quite frequently for good reason. I’ve been in this business for nearly 25 years now, and I would consider the covered call one of the most frequently used combination positions and for good reason. It’s flexible, it’s fairly straightforward. So, let’s walk through the kind of how and why they are pretty straightforward. It combines something that many of your listeners, many, what we refer to as market participants, are already familiar and comfortable with in the form of long equity exposure. So, you bought shares of XYZ; the stock that you’ve been following, that’s long equity exposure. Now I’m going to assume 100 shares, and that is combined with a short call option, a sold call option. So, we’ll just briefly walk through the two components of the covered call: Long 100 or more shares or units of an underlying security or ETF. Short one per each 100 shares of the underlying, typically an out-of-the-money call option. So, it’s sold. That comes with the obligation to sell 100 shares of that security at the strike price if you are assigned. And for assuming that obligation you’re taking in a premium. Now that full position has defined risk in both directions, but it’s very significant on the downside. When you combine say 100 shares of Apple and short an out-of-the-money call you collect premium and whatever premium you collect, it cushions your long equity exposure by that amount. So, if you bought a stock for $10, you sold, just to make the the math easy, a $12.50 strike call and collected a dollar, you would cushion your downside by a dollar. So, you’re cost basis on the underlying security would then be $9 per share. On the upside, you participate on the upside up until a point. And that specific point is your strike price plus whatever you’ve collected in premium. So, just sticking with our example where we had bought 100 shares at $10, we sold a 12 1/2 or $12.50 strike call [option] for a buck. We would be making money up until $13.50 and beyond that point on the underlying, we would not participate. This is something that many people do to potentially enhance yield on an underlying security that they are comfortable owning. What that means is if those call options expire worthless that is enhancing your yield on the long underlying and it also gives you, as I mentioned, the potential to reduce your cost basis in the sense that it cushions downside over the life of that option.

Cassidy Clement

Got it. So, now that we have our basics down, some of the jargon of this concept, the next piece would be actually talking about some hedging conversation points, concepts so people can keep up with it. Now that we’ve given them the main words. So, what would be the difference between hedging a specific stock versus hedging the entire portfolio?

Kevin Davitt

That’s a really good question. I am going to use an insurance analogy here, which again is not a perfect one, but just keep in mind that it’s an analogy. So, protecting a specific stock using options is like having insurance on one automobile. So, that policy covers that specific car for, let’s say, the year, right? It’s got terms, it’s got a maturity, you do not buy car insurance in perpetuity. Now let’s compare that to something like an umbrella policy that covers assets more broadly, say that that insurance policy covers your home [and] two cars, there’s life insurance and maybe supplemental health insurance. The long story short, it’s designed to cover more. In that vein, index options are often used to protect a portfolio, assuming that the portfolio behaves very similarly to the index. So, your aggregation of assets typically will behave more or less like one of the broad-based indices, assuming some degree of diversification. If we want to throw a little more jargon in here, the relationship or the correlation between a portfolio and an index is often referred to as beta. If you have a beta of one, your portfolio tracks that given index one to one. That would be unusual, but the closer to one, the more likely that index would be a good tool as a hedge vehicle. Now, there are a variety of index products with different sizes. And we can go into some of the specifics there. But if you think of it like through the insurance analogy, it’s sort of like how they offer just coverage for what you need and sized appropriately. So, in short, you can protect a single automobile or you could protect your assets more broadly. A hedge on a specific stock is offsetting the risk that you have associated with that underlying. A portfolio hedge is designed to offset that risk of the entire asset base more comprehensively. Did that make sense?

Cassidy Clement

So, I know that you mentioned indices and index options, so sometimes they have a designation to an economic sector. How would you explain how an index is different from just investing in things in the same sector.

Kevin Davitt

That is another really good question, and just anecdotally, I had similar conversations to this with friends recently where I sort of posed a question to them. Do you view something like the S&P 500, the NASDAQ 100, the Russell 2000 as essentially interchangeable or ultimately sort of the same thing? And by and large, their answer was yes, and that surprised me. Now, these are bright people, but I have to keep in mind that so many people do work that’s outside of capital markets, and I work specifically on an index options team so I I’m sort of in this every day. So, let me explain the difference between a sector and an index as best I can. I’m going to go again with an analogy here. The way I think about this is that if you have a recipe, there could be any number of different ways to make a chicken curry or an apple pie or whatever your favorite recipe is. They’re combining a group of ingredients in different weightings to get the taste that you’re looking for. Is this sort of making sense? So far, yeah. You have some discretion or some choice with regard to the makeup or the different weights that you give in the recipe analogy to spices, or something like that. So, when I look at the well-known broad based U.S. equity indexes, the default tends to be the S&P 500, and so I think about, well, what are the ingredients? What are the the weightings for this apple pie? We’ll call them all apple pies. Now, they change over time based on shifts in the economy. But here and now the full S&P 500 has different weightings based on different sectors. How companies are grouped, what they fall into, and there are very specific categorization methodologies for securities. So, technology has come to dominate our economic system and it is reflected that way in different indices. So, the technology sector accounts for nearly 26% of the S&P 500. That’s followed by financials, which make up almost 15% and then you have healthcare and consumer discretionary both in the ballpark of 13% there. You go down to the the smaller weightings and you have things like industrials, consumer staples, energy, materials, much smaller weighting to something like real estate or telecom, but the full thing and the weight of those different ingredients are what make up the S&P 500. Many of the same sectors are included in the NASDAQ 100 weighting but with different weights or the NASDAQ 100 index. So, let me walk through those and just do a little comparison. The NASDAQ 100 is skewed towards technology. So, I mentioned that it made-up about 26% of the S&P 500. Technology companies make up nearly 58% of the NASDAQ 100. So, pretty much double the weighting of the S&P 500. Behind that you have consumer discretionary which is nearly 19%. You have different weightings for, let’s see here, I’m just looking through a handful now. Telecom industrials, very small weighting in materials. One thing I do want to call a meaningful distinction between the two on is financials. The NASDAQ 100 does not include financials and that is a fairly significant difference between the two indices. So, hopefully tying this all together, different sectors are looked at and compared to one another, and individual companies are assigned to a given sector depending on the the business that they operate in. So, if you think about Apple, they would fall in the technology sector. If you think about Amazon, they’re typically considered consumer discretionary. A company like Tesla also would be a a consumer discretionary name. When you think about financials, those are typically the big banks. They are represented fairly heavily in the S&P 500 recipe. They are not in the NASDAQ 100. So, again going back to the original analogy about the music that’s important to you or the authors that are important to you, analyzing which index better reflects how you would like to express your view about the economy writ large and what sectors you believe deserve a little more weighting in your recipe is very much an individual choice. But it’s an important one because they have implications for how these different indices perform over time.

Cassidy Clement

So, if we were to take all of this and then kind of put it into a hypothetical example to give an idea to the listeners. If we were to hedge, let’s say you use technology stocks, a portfolio of some technology stocks, what type of choices would the investor have and what products are typical to a retail stock?

Kevin Davitt

The investor these days has a wide, wide variety of alternatives to choose from and on the face of it, I think that’s a wonderful thing. We have tremendous choice when you think about just going to the grocery store or shopping for clothes. But sometimes it can be a little overwhelming, particularly if you’re newer to this and it can just make you throw your hands up and say, “I don’t understand this!”. But, with a little bit of work, you can really understand the differences between your choices and why those exist. You could choose to look at your basket of technology stocks and hedge your exposure to each individual security like we described earlier. That’s an alternative. You could look to a sector-based ETF, and see how well your grouping of securities, what sort of beta it had relative to that ETF and you could use options on that ETF to ostensibly offset some risk that you have in your portfolio. And then many people look to index products when they have a reasonably diversified portfolio. So, something that may not necessarily just be technology based, but includes some other sector exposure. If you were going to look for an index option to heavy technology exposure, I would argue that the NASDAQ 100 is much more representative there because it’s weighting in that specific sector is significantly higher. And then you have different products with different notional exposure. Ultimately, what I mean by that is, I think about products that we buy like, let’s just say pretzels. You could go to 711 or a convenience store and get a small bag of pretzels. You could go to a Kroger or a bigger retail chain and get a normal-sized bag of pretzels. Or you could go to Costco and get a very big one for a party. It’s all the same pretzels. Or you can make the analogy with pop. I could get a single can. I’m from the Midwest, so it’s pop, soda for the rest of the world, you get a single can of Coca-Cola or Pepsi at a convenience store. You could get a 12 pack at the grocery store, or you could get a 30-pack at Costco. These index options come in that sort of sizing difference. But the reference asset underlying those different sizes is the same. Hopefully that makes sense, but we get our group, our index options group, gets a lot of questions about that, and I would welcome –  I can leave the e-mail (indexoptions@nasdaq.com) that’s best suited for those kind of questions, if it’s appropriate. And I can most certainly not do that if it’s inappropriate.

Cassidy Clement

OK, so it seems that the investor has an option with the size and type of their hedging opportunities, but usually, like you used in your analogy, that underlying asset or that reference asset it’s, you know, tending to be the same. But what would you say to investors when they’re looking at researching or reviewing some hedging opportunities? What are some main points to look at that they should keep in the back of their mind?

Kevin Davitt

That’s a really good question. I do think it’s very personal. And the more you reflect on what it is you’re really looking to do, as opposed to just going through a routine, I think the better. So, what that lends itself to is genuine analysis of time frame. Time frames matter with any derivative contracts because they expire and typically hedges are performance and hedges are looked at on an annual basis. And so oftentimes looking at options that have a longer dated maturity, so say a year or more in the future, those tend to be what hedgers gravitate toward. And I would also consider, this is difficult but, isolating positions that you put on as a hedge from those that you use for more shorter term expressions because I have spoken with people where they will turn a position, something shorter in nature, into a longer term position based on a short term move and if you are clear from the outset about like I am putting this on to hedge my portfolio exposure over the next 12 months and you set it and forget it. That tends to work best in my opinion, and I would also point out that hedges are designed to lose money. And that runs counter to most of the the goals that we have in capital markets. But the analogy, they’re sort of sticking with our theme is, you don’t buy car insurance hoping to find out how it works, you are just grateful you have it in the event of an accident. And so, do not think about hedges as an opportunity to make money because it’s offsetting a pre-existing price risk and that’s why I think really delineating whether it’s in a different account or something, a different side of the Ledger. This is hedging activity and and what’s on the other side is something different, can be real helpful to not jumble them up mentally three months in or four months in.

Cassidy Clement

I think that’s probably one of the best points for people just looking at doing some diversification and looking at hedging is that it’s meant to limit the risk. It’s not meant to be another opportunity for you to come up so strong and make all this money. It’s to help protect your money that’s already in the system. So, these are all great points. Thanks so much, Kevin. Thank you for joining us. As always, listeners can learn more about an array of financial topics for free at IBKRcampus.com. Follow us on your favorite podcast network and feel free to leave us a rating or review. Thanks for listening.