In the world of investing, a debate that often takes place is on how to best hedge a portfolio.  The answer may be simple at first, but when you look at a deeper level, there are a lot of questions to be answered before making a decision on how to hedge as there are a lot of choices.  The choices that we will discuss today are the advantages and disadvantages of active vs. passive hedging.

Let’s begin by going over what we consider an active and passive hedge. 

A passive hedge is something that would require no adjustments and have no positions closed until the final expiration date.  In other words, if you bought a put option to hedge a stock, you would not close the position until the date of expiration or you would simply exercise it yourself.  The only decision that would have to be made would be if you wanted to continue to own the stock itself AFTER the expiration of the option.  If you wanted to continue to own it, you could close the put option position (or let it expire worthless if it is OTM).  If you didn’t want to own it, then you could exercise the put option (assuming it is ITM).

An active hedge is one that would have adjustments done to the position during the life of holding the underlying.  An example would be if you created a large profit in your protective put option, and sold it.  After you sold it (the put), you used the money to buy more stock with the profits you took from the profitable put.  I like to think of this as letting the market pay for your dollar-cost-averaging.  You can then continue the hedge, or you can simply own the stock outright.  The decision would be up to the investor.

The main advantage of passive hedging is that you know exactly what you are going to get.  At expiration, implied volatility goes away and you simply have an ITM or OTM option.  You know that it is mathematically impossible for you to make or lose more then a certain amount.  The other advantage is that you know you won’t make any bad trades during the duration of the trade.  The reason is that you won’t make ANY trade.  It is a passive hedge.

The disadvantage of a passive hedge (and potentially the advantage of an active hedge) is that you will miss out on opportunities that happen during the life of the hedge.  For example, if you have a large profit in a put option, and you would then be fine owning the stock outright at that level, then you would hold onto the stock AND the put.  The reason is that your rules dictate that this would be a passive hedge.  Thus, unless you want to break your rules as an investor, you would have to remain in the put option until expiration.

Ultimately, it depends on what you are trying to do as an investor.  Through our group of clients, we have done a mix of both styles through the years and will continue to do a mix.  We don’t believe that one is better than the other.  It is up to the individual needs of the client.

For more information on what we do, feel free to email mtosaw@rcmfs.com.