How to Hedge Your Tech Stocks
Portfolio hedging is an underrated skill and particularly useful in volatile markets. It’s a superpower few investors have. Those who know to hedge can outperform significantly during both bull and bear markets.
When the Nasdaq-100 crashes and goes into a downtrend, most investors don’t know better but to hold and hope that their tech stocks will recover. Few know how to protect their portfolios during a market correction.
It doesn’t make sense to liquidate the entire portfolio. You carefully analyzed stocks before investing in them, so it often makes sense to ride out a short-term correction. The market could recover fast after all.
What to Use For Hedging Tech Stocks
What you need is a cushion that dampens the impact during a market correction. The best way to hedge a tech-heavy portfolio is with the E-mini Nasdaq-100 (NQ), or with the Micro E-mini Nasdaq-100 (MNQ) for smaller portfolios. Both are futures contracts on the Nasdaq-100 index.
Futures contracts are the most cost-efficient way to get direct exposure to the underlying index because they are traded on margin. You only need to deposit a minor percentage of the notional value that you want to protect.
Margins vary among brokers but they tend to be around 6% of a contract’s notional value. You also won’t get charged any interest fees for holding contracts over longer periods.
Understanding Your Portfolio Beta
Let’s say that you hold stocks worth $100,000. When the Nasdaq-100 begins to crash, you sell short 3 MNQ contracts. They would hedge almost your entire portfolio.
Here is why: The MNQ has a multiplier of $2. You take the Nasdaq-100 and multiply it by $2 to determine the contract’s notional value. Since the Nasdaq-100 currently stands at 15,000, one MNQ’s notional value is $30,000.
Larger portfolios can be hedged with the NQ which has a multiplier of $20.
In practice, most tech-heavy portfolios need to be hedged with a little more than what they are worth because technology stocks tend to be more volatile. If the market crashes, your stocks often drop faster than the broader index. Your hedge can’t keep up which is why we need to find a way to bridge that gap.
A stock’s volatility is generally expressed with its beta. Beta describes the activity of a stock’s return as it responds to swings in the broader market. You can look it up for each stock.
- A beta of 1 means that the stock swings exactly like the broader market.
- A beta less than 1 or more than 1 suggests that it’s less volatile than the broader market or more volatile, respectively.
- A negative beta means that the stock moves inverse to the market, but is rarely observed because stocks are a strongly correlated asset class.
To calculate how many contracts you need to sell short during a market correction, you have to calculate your portfolio’s weighted average beta.
How to Calculate the Weighted Average Beta
Let’s assume that a portfolio holds three tech companies in various quantities: Apple, Facebook, and Tesla. Next, you look up the beta for each stock and multiply it by its weight in the portfolio:
|Beta (August 2021)
Sum up the weighted betas to find the weighted average beta of your portfolio. In this example, it’s 0.60 + 0.26 + 0.59 = 1.45. What this number means is that the portfolio generally swings 45% stronger than the benchmark.
As a consequence, you need to sell short 5 contracts to effectively hedge your portfolio during a market correction. 5 contracts are a $150,000 notional value which is 50% more than our sample portfolio. The hedge almost perfectly balances out the adverse market move. While your stocks lose in value, your hedge will gain in value.
The Portfolio That Never Loses
Technology investors come to me because they want to know when they need to put on a hedge using trend following signals.
As the market moves lower, your short position builds up a surplus cash balance that you can deploy back into stocks at market lows as soon as the market turns back bullish.
You have thereby established a portfolio that never loses. This is a powerful concept because you avoid market timing and can make rational and systematic trades with proven trend following systems.
If you want a good night’s sleep, you should definitely learn trend following with me.
Published Sat Aug 28 2021 (last modified Fri Nov 04 2022)