Hedging Methods

Stop-loss limit orders are a foundation for limiting downside risk at Pacific Park Financial, Inc. Similarly, stop-gain orders may also be employed to secure a desirable outcome.

There are other methods that serve as a form of insurance. One such technique involves the use of negatively correlated assets, or “hedging.”

Many folks believe they are “hedging” when they buy shares of the SPDR Gold Trust (GLD). The truth is, they may not be. Historically, gold has been an excellent hedge against inflation and currency devaluation. Yet in one three-year stretch (2008-2010), GLD exhibited a high positive correlation (.80) with the S&P 500… moving in the same direction as the stock market on 4 out of 5 occasions.

When Pacific Park Financial, Inc. decides to hedge, we are looking to significantly lower the impact of disastrous events. This insurance, or hedging, requires a genuine search for negative relationships between two assets.

For example, let’s say that you’ve purchased 400 shares of the SPDR Energy Select Sector Fund (XLE) on January 1 for $60 at a cost of $24,000. XLE subsequently reaches $72 in mid-December ($28,800), though there is credible analysis to suggest oil prices may slide precipitously.

Indeed, a stop-limit loss order on XLE may secure a short-term taxable gain of about $2,000 at $26,000. On the other hand, it can’t keep you invested through the end of year to preserve a long-term, unrealized capital gain. What can you do? You can consider “hedging” with ProShares Short Oil & Gas (DDG) — an ETF that has a -.95 negative correlation with XLE. One could purchase $14,400 of DDG for a partial hedge position, or perhaps cover XLE completely with $28,800 worth of DDG.

At Pacific Park Financial, Inc., we’re unlikely to use “Short ETFs” except to hedge positions. Ideally, one is looking to mitigate a risk for a brief period.

For instance, let’s assume that a portfolio has a large stake in U.S. stocks — from S&P 500 SPDR Trust (SPY) to First Trust Morningstar Dividend Leaders (FDL) to iShares Russell MidCap Growth (IWP). It is not practical to purchase a hedge for each position, but it is practical to add an investment that moves higher when U.S. stock assets of all shapes are moving lower.

Enter Currency Shares Japanese Trust (FXY) with a negative correlation of -.80. In essence, 80% of the time, FXY will gain in price and serve to offset U.S. stock depreciation. Using FXY sparingly and judiciously may reduce the impact of bearish downtrends.

“Hedging” is one method that Pacific Park Financial, Inc. employs to protect client account values. The sensible use of “stop orders” is another. Now let’s turn our attention to another tool in our shed… strategic diversification.