How to Hedge Your Portfolio: Strategies to Protect Your Investments

Markets don't go up forever. Bull markets end, corrections happen, and crashes occur. While long-term investors eventually recover from downturns, sometimes you need to protect your portfolio—whether you're approaching retirement, have concentrated gains, or simply want to reduce anxiety during volatile times.

This guide covers practical hedging strategies from simple to sophisticated, along with the costs and trade-offs of each approach.

What Is Hedging?

Hedging is taking a position that profits when your main investments lose value. It's portfolio insurance—you pay a cost in exchange for protection against losses.

The Insurance Analogy

Why Hedge?

Reasons to hedge:

• Protect large unrealized gains
• Reduce portfolio volatility
• Sleep better during market turbulence
• Approaching time when you need the money
• Concentrated position you can't or won't sell
• Extreme market valuations or warning signs

Reasons not to hedge:

• Long time horizon (20+ years)
• Hedging costs compound over time
• Timing hedges is difficult
• Reduces long-term returns if done constantly
• May sell at the worst time anyway

Hedging Methods Overview

Strategy 1: Cash Allocation

The simplest hedge is holding cash.

How It Works

Cash doesn't lose value in market crashes (ignoring inflation). By holding a percentage in cash, you limit your downside exposure.

Example:

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Portfolio: $500,000
90% stocks ($450,000), 10% cash ($50,000)

Market crashes 30%:
Stocks: $450,000 → $315,000 (-$135,000)
Cash: $50,000 → $50,000
Total: $365,000 (-27% instead of -30%)

Cash Allocation Guidelines

Pros and Cons

Pros:

• Simple to implement
• No specialized knowledge required
• Provides buying opportunity when market crashes
• No decay or expiration

Cons:

• Opportunity cost (cash earns less than stocks long-term)
• Inflation erodes purchasing power
• Hard to time when to raise/lower cash
• Still lose money on invested portion

Where to Hold Cash

For hedging purposes, safety is priority:

Strategy 2: Bonds and Treasuries

Bonds often rise when stocks fall, providing a natural hedge.

The Stock-Bond Relationship

Historically, when stocks crash, investors flee to bonds ("flight to quality"), pushing bond prices up.

2008 Financial Crisis:

• S&P 500: -37%
• Long-term Treasuries: +26%

2020 COVID Crash:

• S&P 500: -34% (peak to trough)
• Long-term Treasuries: +21%

Types of Bond Hedges

Implementing Bond Hedging

Treasury ETFs for hedging:

• SHY: Short-term Treasuries (1-3 year)
• IEF: Intermediate Treasuries (7-10 year)
• TLT: Long-term Treasuries (20+ year) - Best crash hedge
• GOVT: All Treasuries blend

Allocation example:

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Conservative hedge: 70% stocks / 30% bonds
Moderate hedge: 80% stocks / 20% bonds
Light hedge: 90% stocks / 10% bonds

Limitations

The 2022 problem: In 2022, both stocks AND bonds fell together (rising rates hurt bonds). This correlation breakdown was unusual but showed bonds aren't a perfect hedge, especially when inflation is the concern.

Strategy 3: Diversification

Owning assets that don't move together reduces overall portfolio volatility.

Uncorrelated Assets

The All-Weather Approach

Ray Dalio's "All-Weather Portfolio" concept spreads across assets that perform differently in various environments:

Sample all-weather allocation:

• 30% Stocks
• 40% Long-term bonds
• 15% Intermediate bonds
• 7.5% Gold
• 7.5% Commodities

Gold as a Hedge

Gold often rises during market panics:

Historical performance in crashes:

• 2008: Gold +5% while S&P -37%
• 2020: Gold +24% for the year
• Averages positive in most recessions

Gold allocation: Most advisors suggest 5-10% for hedging purposes.

How to own gold:

• GLD, IAU: Gold ETFs tracking price
• SGOL: Physical gold backing
• Gold miners (GDX): Leveraged gold exposure

Strategy 4: Protective Puts

Protective puts provide the most direct portfolio insurance—but at a cost.

How Protective Puts Work

A put option gives you the right to sell at a specific price (strike) by a specific date (expiration). Buying puts on stocks you own limits your downside.

Example:

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Own: 100 shares at $100 ($10,000 position)
Buy: 1 put option, $90 strike, 3 months out
Cost: $2.50 per share ($250 total)

Scenarios at expiration:

Stock at $110:
- Shares worth $11,000 (+$1,000)
- Put expires worthless (-$250)
- Net: +$750 (reduced by put cost)

Stock at $70:
- Shares worth $7,000 (-$3,000)
- Put worth $20 per share (+$2,000)
- Net loss: -$1,000 - $250 premium = -$1,250
- Without put: Would have lost $3,000

Put Protection Levels

Hedging a Full Portfolio

To hedge an entire stock portfolio, buy puts on a market index:

SPY puts (S&P 500 ETF):

• Most liquid options market
• Broad market protection
• Doesn't protect against individual stock risk

Portfolio hedge example:

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Portfolio: $500,000 in stocks
SPY trading at $450
Portfolio equivalent: ~1,111 shares of SPY

Buy 11 SPY puts, $405 strike (10% OTM), 3 months
Cost: ~$5 per share × 1,100 = $5,500 (1.1% of portfolio)

This protects against losses beyond 10%
Maximum portfolio loss: ~11% ($55,000 + put cost)

Rolling Puts

Puts expire, so ongoing protection requires "rolling":

1. Before expiration, sell existing puts
2. Buy new puts with later expiration
3. Repeat quarterly or as needed

Annual cost of continuous put protection:

• 10% OTM puts: 4-8% of portfolio value per year
• 5% OTM puts: 8-15% per year
• This significantly reduces long-term returns

When Puts Make Sense

Best situations for protective puts:

• Large unrealized gain you want to protect
• Tax reasons prevent selling
• Specific event risk (election, earnings)
• Short-term protection need
• Approaching a financial goal

Strategy 5: Collar Strategy

A collar provides protection at zero or low cost by giving up upside potential.

How Collars Work

A collar combines:

1. Protective put (buy) - Limits downside
2. Covered call (sell) - Caps upside, pays for put

Example:

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Own: 100 shares at $100
Buy: $90 put (costs $2.50)
Sell: $110 call (receives $2.50)
Net cost: $0 ("zero-cost collar")

Outcomes at expiration:
Stock at $120: Capped at $110 (shares called away)
Stock at $100: Keep shares, options expire
Stock at $70: Sell at $90 (put protects you)

Collar Range

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        $110 ──────────── Upside cap (sold call)
          │
          │   Profit zone
          │
Current → $100
          │
          │   Loss zone (limited)
          │
         $90 ──────────── Protection floor (bought put)
          │
          │   Protected (put covers losses below $90)

When to Use Collars

Ideal situations:

• You're satisfied with capped gains
• Want free or cheap protection
• Holding concentrated stock position
• Willing to potentially sell shares
• Short-term protection need

Not ideal when:

• You expect big upside moves
• Want unlimited profit potential
• Long-term investment horizon

See our covered calls strategy guide for more on the call-selling side.

Strategy 6: Inverse ETFs

Inverse ETFs go up when the market goes down—instant hedging without options.

How Inverse ETFs Work

The Daily Reset Problem

Critical warning: Inverse ETFs reset daily. In volatile markets, they can lose money even when you're right about direction.

Example of decay:

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Day 1: Market -5%, Inverse +5%
Day 2: Market +5.26%, Inverse -5.26%

Market back to start (100 → 95 → 100)
Inverse ETF: 100 → 105 → 99.47 (lost money!)

Leveraged ETFs decay even faster.

Using Inverse ETFs Correctly

Do:

• Use for short-term hedges (days to weeks)
• Monitor daily
• Understand the decay mechanism
• Size position appropriately

Don't:

• Hold for months or years
• Use as set-and-forget hedge
• Assume -3x means 3x protection over time
• Use with money you can't afford to lose

Sizing an Inverse ETF Hedge

For a partial hedge:

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Portfolio: $500,000 stocks
Want to hedge 20% of risk
Use SH (1x inverse)

$500,000 × 20% = $100,000 in SH

If market falls 10%:
Stocks lose: $50,000
SH gains: ~$10,000
Net loss: $40,000 (20% less than unhedged)

Strategy 7: VIX-Based Hedging

The VIX (volatility index) spikes during market crashes, making VIX products potential hedges.

How VIX Hedging Works

VIX typically:

• Trades 12-20 in calm markets
• Spikes to 30-40 in corrections
• Can hit 50-80+ in crashes (2008, 2020)

VIX products:

• VXX: VIX short-term futures ETN
• UVXY: 1.5x VIX futures ETF
• VIXY: VIX futures ETF

The Decay Problem

VIX products suffer severe decay from rolling futures contracts:

VXX long-term performance:

• Has lost 99%+ of value over its history
• Not suitable for buy-and-hold
• Only for short-term tactical hedges

When VIX Hedging Works

VIX hedges work best when:

• Bought before volatility spikes
• Held for very short periods
• Sized very small (1-3% of portfolio)
• Used for specific event risk

Better approach: Own VIX calls rather than the products themselves:

• Limited loss to premium paid
• Profits if VIX spikes dramatically
• No decay from holding the underlying

How Much Should You Hedge?

By Time Horizon

By Risk Tolerance

By Market Conditions

Hedging Costs and Trade-offs

The Cost of Protection

Every hedge has a cost:

Impact on Long-Term Returns

Example: $100,000 over 20 years

The trade-off: Hedging reduces volatility but significantly impacts compounding over decades.

When Hedging Costs Are Worth It

Hedging makes sense when:

• You need the money within 5 years
• A major loss would devastate your plans
• You can't emotionally handle big drawdowns
• You have large concentrated gains to protect
• Specific short-term risk event

Common Hedging Mistakes

Mistake 1: Hedging Too Late

Problem: Buying protection after the crash starts

Why it fails:

• Put options become extremely expensive
• VIX products spike in price
• You're locking in losses, not preventing them

Solution: Hedge when you don't need it, not when you're scared

Mistake 2: Over-Hedging

Problem: Spending too much on protection

Why it fails:

• 5% annual hedging cost devastates long-term returns
• Portfolio never grows significantly
• Insurance costs exceed potential losses

Solution: Accept some volatility, hedge selectively

Mistake 3: Wrong Tool for Duration

Problem: Using short-term tools for long-term hedging

Why it fails:

• Inverse ETFs decay over time
• VIX products lose 50%+ annually
• Rolling puts is expensive

Solution: Match hedging tool to time horizon

Mistake 4: Hedging Then Panicking Anyway

Problem: Paying for hedges, then selling stocks during crash anyway

Why it fails:

• Pay hedging cost AND lock in losses
• Worst of both worlds
• Emotional decisions override strategy

Solution: Have a written plan before market stress

Mistake 5: Not Removing Hedges

Problem: Keeping hedges during recovery

Why it fails:

• Hedges hurt you in rising markets
• Drag on portfolio during best times
• Recovery gets dampened

Solution: Have exit criteria for hedges, not just entry criteria

Building a Hedging Plan

Step 1: Define Your Need

Ask yourself:

• When will I need this money?
• How much loss can I tolerate?
• Do I have specific concentrated positions?
• What am I actually worried about?

Step 2: Choose Appropriate Tools

Step 3: Size Your Hedge

Conservative guideline:

• Don't spend more than 1-2% annually on hedging
• Don't allocate more than 20% to hedge positions
• Accept some unhedged risk

Step 4: Set Exit Criteria

When will you remove hedges?

• Market drops X%
• Valuation reaches reasonable level
• Personal situation changes
• Options expire

Step 5: Review Regularly

Quarterly check:

• Are hedging costs acceptable?
• Has my risk tolerance changed?
• Is the market environment different?
• Should I adjust hedge size?

Frequently Asked Questions

What does it mean to hedge a portfolio?

Hedging a portfolio means taking positions that will increase in value if your main investments decline. It's like insurance for your investments—you pay a cost (premium or reduced upside) in exchange for protection against losses. Common hedging methods include buying put options, using inverse ETFs, holding cash, and diversifying across uncorrelated assets.

What is the best way to hedge against a market crash?

The most direct hedge against a market crash is buying put options on the S&P 500 (SPY puts) or broad market index. For those who don't use options, holding 10-20% in cash or Treasury bonds provides a buffer. Inverse ETFs like SH or SPXU can also provide crash protection, though they're designed for short-term use only.

How much does it cost to hedge a portfolio?

Hedging costs vary by method. Put options typically cost 1-3% of portfolio value annually for modest protection (5-10% out-of-the-money puts). Collar strategies can be zero-cost but cap your upside. Holding cash costs you the opportunity of potential gains. Most investors find 1-2% annually is a reasonable insurance cost.

Should I hedge my portfolio all the time?

Most investors shouldn't hedge constantly because hedging costs reduce long-term returns. Consider hedging when: you have large concentrated gains to protect, market valuations are extreme, you'll need the money within 1-2 years, or you're approaching retirement. Long-term investors often accept volatility rather than pay ongoing hedging costs.

What is a protective put?

A protective put is buying a put option on a stock you own, giving you the right to sell at the strike price regardless of how far the stock falls. For example, if you own shares at $100 and buy a $90 put, your maximum loss is $10 per share plus the put premium. It's like insurance with a deductible.

Related Articles

• Covered Calls Strategy - Income and partial protection
• Trading Risk Management Guide - Broader risk management
• Diversification Guide - Reducing portfolio risk
• Federal Reserve Explained - Understanding rate risk
• Market Cycles Guide - Timing market environments
• What Does Risk-Off Mean - Market risk environments
• Trading Psychology Guide - Managing fear and greed