Question

Determine two to three (2-3) methods of using stocks and options to create a risk-free hedge portfolio can be created. Support your answer with examples of these methods being used to create a risk-free hedge portfolio.

Answer 1

There is no ideal strategy or method to create a risk-free hedge portfolio. The methods listed below could also be taken as a defensive strategy to limit the losses when the market is averse. However, the most commonly method used is by investing in inverse equities.

a. Inverse Equities

Under such a strategy, you gain as the market declines. This may be achieved by shorting the market or buying an inverse equity. In doing so, this gives the investor a profit, if the market declines. If an investor has allocated 10% of his portfolio under this strategy, it safeguards him against decline on 10% of his equity exposure

b. Options

Buying a protective put option. This is another strategy in use, since the maximum loss potential gets limited to the option amount you spent. This essentially puts a bet that the market would decline and reaping benefits when the market really declines.

c. Stay in liquid cash

The easiest way to hedge against any losses is to maintain liquid cash. This not only provides liquidity, but is beneficial in the short-term as the monetary value of the cash does not change frequently. However, this is a defensive approach and would not garner good returns in the long-run as the monetary value does not increase as well.