Is the market too high? Are you thinking of hedging your portfolio?

Stock markets are at record high. Just this year, the Standard & Poor’s index rose over 8%. Should you think about hedging your portfolio and how to do it?

There are several ways to hedge against a drop in the market, you could buy puts on the S&P 500 or even short some stock, but many of these alternatives are very expensive and risky. At current levels, there is an opportunity to hedge part of your portfolio, and, while achieving this protection, you will be reducing the total risk of your investment.

At record low levels, the VIX (A real-time volatility index that represents the market's expectations for the relative strength of near-term price changes of the S&P 500 index), is a very good alternative to protect your investments. When the VIX is low, the negative correlation to the S&P 500 index makes it possible.

What financial instrument should I use?

There are several ways to place a hedge using the VIX. The most common is to use futures traded in the Cboe and Exchange Traded Notes. I personally like the ETFs, provides an easy way to buy or sell the securities.

Within the range of ETFs, you might find VXX and VIXY, both have a similar structure and

management fees, and are a great way to play the VIX, as a hedge to protect a portfolio against a market crash.

As the Cboe explains “One of the biggest risks to an equity portfolio is a broad market decline. The VIX Index has had a historically strong inverse relationship with the S&P 500® Index. Consequently, a long exposure to volatility may offset an adverse impact of falling stock prices.”

Ok, now, we decided to use VXX, what’s next?

Well, the next step is deciding if you want to buy it cash or use options. This is a tricky situation, since you should know very well how to trade options before using any kind of derivatives. But if you are already familiar with options, we should go to next level.

How many option contracts, should I buy?

Some analysts have established that on average, the VIX will rise 16.8% on days when the S&P 500 index drops at least 3%. Now, let´s take a look at last year’s crash in march, the S&P 500 dropped 33%, while the price of VXX rose 363% (it actually moved 10 times in the opposite direction).

You should also take in consideration the correlation of your portfolio to the S&P 500. How much your portfolio moves with every change of the Index. A beta of 1.0 reflect full correlation.

You might want to buy out of the money calls to reduce the cost of the hedge, probably 20% over the price of the stock (ETN) and buy a number of calls that equals the upside of the amount you might lose during a big market correction. One simple way to have a good hedge could be:

1. Divide the market value of your portfolio by 10 (inverse proportional return of VXX against SPY)

2. Divide this amount by the value of VXX, times 100 (number of shares per contract).

For example:

Your portfolio has a market value of US$ 500,000. VXX price is US$10.30

Number of contracts= (500,000/10)/((10.3x100))

Number of Contracts= 48

This way you can have an idea of how many contracts you need to buy in order to protect the portfolio. Since, there is no perfect hedge, you should know that if the market keeps going up, you will lose that premium. It is like having insurance and not using it.

You also might want to finance that call selling an out of the money put (20% under the current price). This option strategy is also known as the reverse collar.

As always, this strategy needs a lot of understanding and research. It demands knowledge and discipline too, but what makes all this worthwhile is the passion and the love for the financial dealings to make sure that you get the best out of your hard-earned invested amount and reduce the risk of market corrections.

Before implementing any investment or hedge strategy, you should consider talking to a financial advisor.

Disclosure: I have positions in the stocks mentioned. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it . I have no business relationship with any company whose stock is mentioned in this article.