How does a hedge work

Securing your portfolio with options - tips and strategies to secure your portfolio with CFDs, certificates and more!

Last updated & checked: 10.03.2021

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Strategy tips that will let you sleep peacefully even when share prices are falling

When you buy stocks, you are betting on rising prices. However, the courses can also fall. So you need protection for your depot! We have all the information on how to secure your depot!

You become a co-owner of a company by buying shares. This means that you automatically bet on rising share prices. Many inexperienced investors underestimate this simple connection. Experienced stock traders know and look for ways to keep their stock position just in case - unexpectedly falling prices - to secure. A single share can be easily hedged with option products, but there are also other strategies such as futures, certificates or CFDs. Stock market professionals rely on hedging, which means they operate systematic securities account protection.

With stocks, you always bet on rising prices

Anyone who trades in stocks or traditionally invests in funds relies on a so-called Long strategythat means it is bet on rising prices. Basically, betting on rising prices is a good idea, because in the long term, the stock exchanges are actually up. In the short and medium term, however, anything can be expected on the stock exchanges. Many consecutive days with falling prices for a share - or an entire stock index - are also part of everyday life on the markets. A portfolio that consists exclusively of shares can therefore theoretically not be safe at all, no matter how “safe” the shares that have been selected are. That is why it makes sense to think carefully before buying shares which strategy to use when prices are falling. The following strategies are basically possible:

  • Wait and sit out
  • Buy more when prices have fallen
  • Sell ​​at a loss
  • Speculate directly on falling prices
  • Protect your portfolio with options
  • Secure your deposit with warrants
  • Secure your deposit with CFDs
  • Secure your depot with certificates

Falling courses? A strategy would be better now!

There are very different ways in which you, as an active private investor, can deal with falling prices. Some strategies can be implemented in the short term, others require preliminary planning:

Option 1: do nothing. If you as an investor of substance and potential of the company are convinced, there is no compelling reason to intervene in the case of slightly or sharply falling prices. The price losses that have occurred in the meantime will not be converted into real losses without the sale of the shares; It can be assumed that the stock will recover from the losses and sooner or later return to profitability. The more carefully the security is selected through fundamental analysis and technical analysis, the less there is cause for concern. Inexperienced equity investors in particular find it difficult to simply wait. Experts speak of “action bias” and mean: senseless actionism on the stock exchanges.

Option 2:Buy more shares. If the price of a share that is generally considered to be valuable falls well below the cost price, it can make sense to take action. Not with a sale, but with the purchase of additional shares. To do this, however, there must be sufficient liquidity in your own portfolio. The best thing to do is to reserve a corresponding liquidity margin for a possible subsequent purchase of the share, even before the trade, ideally already a certain price, when it is reached, a decision is made whether to buy again or to wait. However, this strategy in the case of falling prices also harbors risks, because by buying more you automatically increase the percentage of this share in the portfolio, so there are more losers in the portfolio.

Option 3:Sell ​​the stock position. If stocks are sold whose prices have fallen compared to the purchase price, losses are always incurred. It should be considered whether a complete or partial exit makes sense. The more solid the stock is, the more likely it is to recover. Selling a stock position quickly and completely can occasionally be the best option to hedge your own portfolio. This strategy can be inevitable, for example, when reports in the press of economic difficulties or an impending bankruptcy of the company are piling up and no solution is in sight. If these issues were not foreseeable when the stock was bought, then this is really bad luck.

Option 4: bet on falling prices right from the start. If the problems were basically already known, it would have been better to speculate against the stock or the market. This is for example via certificates, Options, warrants or contracts for difference (CFDs) possible because these financial instruments can also be used to bet on falling prices. Then one speaks of a short strategy. Professional stock traders like to use the financial instrument futures to speculate on falling prices, but this route is difficult to follow for most private investors, because the required security deposits are high, often several thousand euros.

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Securing your portfolio with options: tips and strategies

A special variant of deposit protection is the sensible combination of long and short. To do this, you always have to buy mirror-image securities, for example a share (long) and a financial product or financial derivative (short), which has the same share as the underlying. There are two basic variants for securing securities accounts with option products: Options and Warrants.

“In business, an option describes a right to buy or sell a certain thing at a later point in time at an agreed price. It is expressly a right and not an obligation. "

An option on a share or a share index is a so-called conditional forward deal because the Option holder (Option buyers) unilaterally has the right to decide whether the option is exercised or not. The option holder has the Writer (Option seller) opposite, which assumes the exact mirror image position.

Option 5: Depot withSecuring options. Unlike warrants, options are no securitized securities. There is therefore only one specific option for each term and subscription price. The subscription ratio between the option and the underlying is usually 1: 1, which means that a share can be bought or sold via an option. Options are, like futures, therefore more of a solution for professional investors or very ambitious private investors with high deposit volumes. Warrants are an alternative for private investors.

Option 6: Depot withHedging warrants. Unlike options, warrants are securitized securities. With warrants there are therefore a large number of variants per term and base value. The subscription ratio between the option and the underlying is usually 10: 1, which means that 10 warrants are required to acquire one share. Securing one or more securities account positions with warrants works like loss insurance. As with any insurance, there are costs involved in securing a deposit. A put warrant is required for protection; the cost of insurance can be estimated using the following formula: Depot position to be insured / level of the corresponding index * subscription ratio. The price of the warrant is based on the two components of the option transaction: term and subscription price. The longer the hedging period and the further the rate to be hedged is away from the current rate, the more expensive the deposit insurance becomes. In return, the corresponding securities account position is protected against price losses.

Complete protection is only possible if the composition of the shares precisely reflects the index, for example if you have invested in index funds and not in individual stocks. If the deposit protection does not have to intervene by insurance, the insurance of course still costs. This is to be tolerated when the prices of the underlying assets have risen sharply, where the return is only reduced by the insurance premium paid. It is more annoying with prices trending sideways, here the insurance costs can result in a de facto loss in the hedged position. Often, for the sake of simplicity, a put warrant on the DAX is used, even if not all DAX shares are present in the depot, but only a representative selection. Below are two examples of how to hedge some DAX shares in a custody accountwith a put warrant.

Example 1:

Total deposit volume: € 60,000
Share of shares from the DAX: € 10,000
Current status of the DAX: 10,000 points
Desired hedging course: 9,700 points
Subscription ratio: 100: 1
Duration of the protection: 4 weeks
Price of the warrant: 1.50 €
Calculation: 10.000 / 9.700 * 100 = 103.1 put warrants required
Insurance costs: 103,1 * 1,50 € = 154,64 €
Insurance costs as a percentage of the deposit position: 1.54 percent

Example 2:
Total deposit volume: € 60,000
Share of shares from the DAX: € 10,000
Current status of the DAX: 10,000 points
Desired hedging course: 9,000 points
Subscription ratio: 100: 1
Duration of the protection: 3 months
Price of the warrant: € 3.00
Calculation: 10.000 / 9.000 * 100 = 111.1 put warrants required
Insurance costs: 111,1 * 3,00 € = 333,33 €
Insurance costs as a percentage of the deposit position: 3.33 percent

That way you operate static protection. Stock exchange professionals, on the other hand, usually rely on the more complex and expensive dynamic protection.

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Securing a deposit: other strategies such as CFDs & certificates

Option 7: Depot withSecure certificates.

Certificates are financial instruments that have been specifically developed for private investors. The underlying values ​​of certificates can be individual stocks, stock indices, currencies or commodities. The same effect can be achieved with a short index certificate as with a put warrant. There are numerous options for the duration, anything is possible between a few days and weeks and continuous endless certificates.

Option 8: Depot withHedging CFDs.

CFDs (Contracts for Difference) are financial instruments that were originally only used in investment banking and hedge funds. They were developed to hedge securities positions in company takeovers and can therefore be used for securities accounts. In the meantime, private investors also have the option of doing business directly with their online broker using CFDs. CFDs can be used for both speculation and hedging.

The strategies "Protect your portfolio with options„, „Securing a deposit with warrants ", Secure the depot with certificates" and "Secure your deposit with CFDs can be carried out very well on the basis of entire markets, for example all DAX stocks or all MDAX stocks. Instead of buying individual shares, for example, shares are acquired in a passive index fund that is traded on the stock exchange. As an investor, you are thus betting on a rising index. Using a suitable financial instrument such as a short index certificate, an index contract for difference or an index call option, you can also bet on falling prices and thus have a safe deposit account. In addition to the transaction costs for buying and selling securities, there are now also costs for securing the securities account. In the case of financial derivatives with leverage, there may be additional financing costs if the securities are held overnight.

Our conclusion. Securing your deposit with options

    1. Share portfolio without protection? with a pure equity investment you are only speculating on rising prices
    2. Secure deposit: There are very different strategies for securing securities accounts
    3. Strategies and Tips: Depot hedging works with options, CFDs or certificates, for example
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