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5 Hedging Strategies for Do-It-Yourself Investors

Jeff Macke

Hedging was once the exclusive domain of institutional, or at least extremely sophisticated investors. For years this exclusivity worked out fine for both individuals and the institutions; bull markets don't need hedging and the institutions liked to justify their existence by making trades only they understood. Now that the bull market is dead Jay Pestrichelli, author of the new book "Buy and Hedge: The 5 Iron Rules for Investing Over the Long Term" says it's time for the layman investor to control their risk, and possibly make some money, by deploying some of the tools of the hedge fund trade.

Here's insight on Pestrichelli's 5 Iron Rules.

1. Hedge Every Investment: Pestrichelli calls this the One Rule readers should take away from the book. No "buy and hold" forever; don't hang on to losers because they can't possibly go lower. If the last 10 years, a period during which Pestrichelli says "buy and hold has gotten its teeth kicked in," has taught us anything it's this: Until a stock hits zero it can always go lower. If you hedge yourself via puts or sell discipline you remove the chances of falling in love with a loser.

2. Know Your Risk Metrics: In short these metrics are Capital at Risk (CaR), volatility, implied leverage, and correlation. No, these aren't the kind of things you're going to read about in the business section of your local paper. Yes, they are critical tools for those who don't wish to fly blind with their life savings. Pestrichelli's book does a pretty good job of summarizing concepts I spent a decent amount of money studying in business school.

3. Smart Portfolio = Long-term Outlook + Diversification: Rather self explanatory.

4. Unleash Your Inner Guru: I can't say I'm on board with unleashing your inner guru. Even gurus don't want to be gurus. That said, the basic idea of doing your homework, understanding your investments, and having the confidence to act on your own opinions is solid. Spouting off on your opinion then refusing to acknowledge mistakes is not a solid approach. And, no, I'm not a guru.

5. Harvest Gains and Losses: Here's where the learning curve gets steep. Pestrichelli offers lessons on using options strategies to effectively take profits off without actually selling your winners. While the methods are somewhat vanilla by the mind-numbing standards of options trading, individuals are entering the deep end of the pool when they start dealing in puts and calls. Comparing options to health, life, and auto insurance, Pestrichelli points out that people make options trades everyday. His book just casts some light on the process.

Having done more than my share of hedging in my past life I can say that it's not for everyone. "Buy and Hedge" offers some terrific, surprisingly comprehensible techniques for controlling risk. That said, options trading is the deep end of the trading pool. The options traders I know are a bit like hardcore card sharps; they may rake in the occasional pot off one another but they make their real living off the greenhorns stumbling into markets they simply don't understand.

Despite this Pestrichell and co-author Wayne Ferbert's basic point is irrefutable: Passive buy and hold investing hasn't worked for years. The techniques described in Buy and Hedged aren't for everyone but the book raises alternative ideas for those looking for alternatives to being held captive by the market's constant to and fro.