Simple Hedging

As the momentum train rolls on in autumn of 2025 and U.S. stocks are seemingly unstoppable while they run ever higher with barely a pause, a number of red flags are beginning to compete with exceptional forward returns of lasting momentum regimes. To be sure, this is not a market that is easy to short, but neither is the rally’s trajectory sustainable over the long term: Something needs to happen to reset the stock market to a more sustainable rate of ascent. Usually, this takes place in the form of a correction in price (a temporary pullback) or a consolidation in time (a sideways range). Historical analogs point to a slow, moderate pullback (4-9%) over several weeks as the most probable path.

Sitting on accumulated gains (hopefully) across investment and trading portfolios, just as we enter the historically worst weeks for the stock market, makes it prudent to think about hedging some of those gains. I am a big proponent of hedging opportunistically with market swings and to keep a challenging problem as simple as possible. Nonetheless, there are a multitude of instruments available, which all have their pros and cons – each would be the optimal choice for a different path.

The basic questions are: How to best hedge a portfolio to align with an expectation of a moderate pullback, specifically when the exact timing of the anticipated drawdown is unclear? Which alternatives are the better option for different paths forward? Does it make sense to hedge at all? What role does the size of our portfolio play?

I think through my preferred methods to hedge or go short detailing major advantages as well as disadvantages. (No single method or instrument is ever optimal and, especially for larger portfolios, it is a good idea to diversify across them and be situationally flexible.)

Rebalancing Profitable Positions

My main investment strategy waits for a decisive, systematic risk-off signal after the market regime has already changed, because it is based on the concept that it is best to remain invested in the stock market the vast majority of the time – its philosophy is to ride out all minor corrections. However, part of the strategy uses 2x leveraged ETFs, which will exacerbate the inevitable drawdown before a strategic exit signal.

A simple profit-protection method is to rebalance the portfolio back to its original size at entry. At pre-defined intervals, it is effectively sizing down by removing accumulated profits. This frees up cash to be stored at decent interest rates, which can be reinvested in a sizable correction. The best part: there is no prediction involved.

Raising Cash
As is done for part of an investment position via the rebalancing method, in most cases the best method to hedge a portfolio is to simply reduce exposure by going to cash. This is not an either-or decision: Keeping a cash position of 10-30%, depending on our outlook, gives us the flexibility to pounce on major opportunities as they appear – even if they come out of the blue!

At the beginning of the year, my stance was to raise a large cash position, as well as implement other hedges, because the indications for a volatile correction in 2025 were very convincing. In the current momentum regime, I raise a smaller amount of cash via rebalancing my portfolio as we go from high to high. The momentum rally is likely to continue after a pullback according to breadth-thrust and momentum market studies.

Hedging With Options

Long Puts
This is the simplest, go-to hedging method that I list in my weekly reports, because it has clearly defined advantages. The premium spent on buying puts exactly defines the cost of hedging or for outright short positions. Put options are also aligned with volatility and in a sudden decline a spike in vol will push put prices up, thereby enhancing their profit potential. The big drawback, however, is the continuous time decay that slowly eats into an option’s value as it moves towards its expiration date – timing put positions well is essential. Because this decay accelerates over time, I opt to hold long-term options with roughly six months to expiration to minimize theta decay.

Puts are best suited to bet on an anticipated, sharp decline in the near future, rather than as a general, always-on hedging overlay, which can be very expensive over time. Therefore, I primarily hold them if probabilities for a short-term decline are substantially elevated. Position sizes are easily calculated using the option’s delta and the complex procedure of adjusting a hedge for changing deltas can be simplified by a rule of thumb: take partial profits at set intervals as the option rises in price.

Currently, there are a number of indications for a likely, moderate pullback listed in my reports, but that has been the case several times over the last months. A lot of premium spent for the expectation of a moderate gain makes this a difficult environment to be buying puts. They can be expected to reduce returns and portfolio volatility in most paths, but are the best hedge against an unexpected market crash.

Bear Put Spread
To lower the cost of hedging and reduce the effect of time decay of a simple long put, it is possible to add a short put at a lower strike to create a put spread. As we are paid the (lower) premium for the short put, all the disadvantages of buying puts are turned into an offsetting advantage for this leg of the spread: time decay and premium work in our favor. On the other hand, if the market crashes the spread’s profit potential is limited below the short put’s strike price and the calculation of the size of the position to hedge a given portfolio is quite complex.

For the current outlook, the strategy is well suited, because a defined, moderate pullback range can be precisely targeted by strike selection.

Short Calls
In case of a high conviction pullback, but with an uncertain starting point and time (and, to be honest, isn’t that the reality we face most of the time?), selling covered calls against existing investment positions has emerged as one of my favorite long-term hedging alternatives. (Beware that naked short calls, without a corresponding long position, carry unlimited risk – this can be mitigated via a call spread.) They will only hedge a crash partially, which in case of a developing bear market will be no more than a band-aid, but in a sideways market with unpredictable up- and down-swings or during mild pullbacks short calls work as an excellent yield accumulator.

For larger portfolios (> 500k, as one ES option is exposed to around $330.000 worth of S&P 500) selling S&P 500 futures (ES) calls carries a combination of potential return streams that are partly known, partly directional- and volatility-based risk premia – all, except the first, also apply for SPY options.
Firstly, the short call will lock in the basis trade of futures versus spot S&P (SPX) of around 1% per quarter. (You can observe this by looking at different futures expirations that trade at consecutively higher price levels above SPX according to the risk-free rate – this spread converges towards expiration.)
The option premium will be paid in cash into your account, where it can earn additional interest of similar magnitude.
The final parameter is the size of the premium itself, the return of which will be realized when you buy back the option. The time decay over long holding times will work in our favor, as will volatility, which tends to fall as stocks rise. These components add up to a substantial yield in case an investment portfolio treads water over many months. I like the strategy, because it forgives many of the inherent difficulties in precise market timing and the risk of outright losses is offset by the investment portfolio’s gain.

The two main disadvantages are that the hedge caps our upside, if the market rallies on further than expected without a correction. A higher option price at expiration (our loss) will correspond to the gains of our investments, which means that profits are limited to the option premium plus the interest earned, even if the S&P trades substantially higher. Secondly, downside protection is also limited to the size of the premium plus interest when the option expires worthless. A deeper decline will remain unhedged. If a 15% correction should start right now, for example, the reward of a short call will be relatively small.

Other Alternatives

Futures
S&P 500 futures (ES) are a very efficient, leveraged instrument to express directional conviction on both the long and short side. However, they carry unlimited risk and have a propensity to trigger margin calls at the most inconvenient times as their greatest drawbacks. When working with a strict stop loss discipline, one can capitalize on futures as the cheapest means to gain substantial leverage (their cost essentially equals the risk-free rate with very tight spreads and low transaction costs, while near-continuous trading eliminates most overnight-gap risks).

On the short side, I see futures less as a hedge, but more as an instrument suitable to short the market in very specific, defined-risk trade setups. In practice, however, I mostly tend to stay away from futures, because small mistakes are magnified and any straying from your discipline will be severely punished eventually.

But the advantage of being able to access leverage without an impact from time decay or changes in volatility is not to be underestimated.

Alternative Instruments
As an investor based in Europe, I have access to a plethora of alternative instruments based on futures. In return for lower efficiency (costs of futures are carried over with some opaque fees slapped on top) they have some advantages that make their use worthwhile to me to express an explicit, directional view on both the long and short side. I frequently use leveraged instruments that swap the volatility- and time dependence of options, as well as the unlimited risk-profile (and possibility of margin calls) of futures, for an increased volatility drag as their major drawback. Fixed-leverage instruments are very similar to leveraged ETFs, but with a wider selection of leverage factors (e.g. ranging all the way from 2-20x for the S&P 500) and many available underlying assets.

Because the leverage factor is recalibrated every morning, a volatility tax is exacerbated in wide market swings. Therefore, these instruments are best suited to trade setups aiming to capture a directional move with few pullbacks. High leverage (8-10x) should not be held through pullbacks larger than 5%, while medium-leverage (4-5x) instruments can be used to target multi-week swings including moderate pullbacks. 2-3x leverage, just like their ETF counterparts, can benefit a leveraged tactical asset allocation with multi-month holding periods. The range of products allows for great flexibility using a liquid, low-cost (tight spreads and zero transaction cost) market.

Selling Puts vs Buying Calls
Not a hedge, but deserving a mention as an alternative to buying calls as a long position, selling put options during a severe market drop with a corresponding spike in volatility can often be an interesting choice. The vol spike makes options significantly more expensive and a subsequent volatility crush can severely limit the upside of calls despite a market move in the right direction (conversely causing a short put to post a substantial profit merely by virtue of falling volatility). Long calls often have a much better reward-to-risk profile, if bought during the recovery period when volatility has already subsided – the right side of the V.

The drawback of a short put is that it is exposed to unconstrained risk, which can come to roost in a continuing liquidity cascade with volatility spiraling out of control (which, of course, is the time when buying puts offers the best reward). This can very quickly eat up available margin in a small- to medium-sized trading account.