Common hedging instruments and their costs
| Hedge Instrument | What It Hedges | Cost | Complexity |
|---|---|---|---|
| Put options | Downside equity risk | Premium (2–5% annually) | Low |
| Inverse ETFs | Broad market decline | Tracking error, daily reset | Low |
| Futures | Directional exposure | Margin, roll costs | Medium |
| Interest rate swaps | Rate risk on debt | Swap spread | High |
| Collar (put + covered call) | Downside protection funded by capping upside | Net zero or small credit | Medium |
Hedge when it is cheap, not during panic
The best time to hedge is when it’s cheap (low IV, calm markets), not when everyone else is panicking (high IV, expensive premiums). Hedging after a crash is like buying fire insurance while the house is burning.
Price a quarter of portfolio insurance
Check the cost of a 10% OTM put on SPY with 3 months to expiration. That’s the price of portfolio insurance for one quarter. Is it worth it to you?
When paying for portfolio insurance is worth it
You can hedge your $1M portfolio with puts costing 3% annually ($30K). Your expected return is 10% ($100K). Should you hedge?
Hedge the risks that force bad decisions
When an 8% hedge is too expensive
You hold $10M equity exposure. Stocks are volatile but long-term positive. Cost to hedge with 1-year ATM puts: $800K (8%). Disciplined response?
Check your understanding
Sit with the ideas.
You hold $500,000 in energy stocks and are worried about a near-term oil price decline, but you believe these companies will outperform over the next two years. What is the most efficient hedging approach?
Why: