How Hedge Funds Are Protecting Their Portfolios

How Hedge Funds Are Protecting Their Portfolios

almost 4 years ago2 mins

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The S&P 500, completed its best 50-day run ever on Wednesday. It’s now only 8% away from its record high of mid-February, leading hedge fund investors to brace for the next drop.

What does this mean?

Investors appear to have seen signs of improving – or at least not worsening – economic and coronavirus data recently, and seem to have been encouraged by central banks in the US, Europe, and beyond committing to do almost whatever it takes to support people, businesses, and the economy at large. And that’s translated into confidence in companies’ prospects, giving the stock market a boost.

Source: Koyfin
Source: Koyfin

But company earnings estimates have fallen dramatically. With rising share prices, that means price-to-earnings ratios, on average, have risen to heights not seen since 2002.

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According to one hedge fund manager, stock markets are now priced for perfection: unexpected negative news – such as further job losses and future business insolvencies – could derail the market’s recovery and send the S&P 500 to new lows.

Why should I care?

If you, like certain hedge fund managers, want to position your investments so that if markets take a tumble, your losses are partly offset by the rising value of other assets, buying put options is one method pro investors use.

Puts give an investor the right to sell shares at a predetermined (a.k.a. "strike") price and become more valuable if stock prices drop below that strike price – partially offsetting losses from the shares themselves.

A put option’s payoff is greater the more the underlying asset’s price falls
A put option’s payoff is greater the more the underlying asset’s price falls

Put options aren’t just confined to shares: hedge funds have also been buying currency puts on the likes of the Korean won and Australian dollar since both are sensitive to shifting risk appetites.

Of course, buying puts costs an investor money upfront – but they hope that’ll be money well spent if exercising their options offsets earlier losses, or simply pocket change lost if their core investments keep rising and the options are left to expire.

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