Here is something that top-performing hedge fund managers know: Bearish positions in a portfolio can make it easier to hold bullish ones.

In other words, if you have positions that are bearish — that benefit when markets fall — it can make it easier to maintain positions that are bullish (which tend to profit when markets rise).

The way this works is through a concept known as hedging. There are different kinds of hedging — and many different types of hedge — but the simple thing to understand is that a hedge is a form of insurance.

The whole reason commodity futures markets were invented, for example, was so that grain buyers and sellers could use futures contracts to take out insurance, or “hedge,” against the inherent business risk in volatile commodity prices.

For example, if a farmer has a large quantity of wheat coming to harvest, the farmer has business risk — possibly even bankruptcy risk — if the wheat price falls sharply before his crop is sold in the cash market.

So the farmer can sell, or go “short,” wheat futures contracts that earn a profit if wheat prices decline. The farmer can do this far in advance of the actual cash sale, while the wheat is still growing in the ground.

If the wheat price then falls, and the wheat futures position is sized properly, the profit from the bearish futures trade offsets the loss from selling physical wheat at a lower price in the cash market. If the price of wheat rises instead, the loss on the futures position is covered by the gains from a higher cash price.

The end users of commodity products have business risk in the other direction. For example, if a food processing company has to buy wheat to make its products, the food processing company would be hurt if the price of wheat rose sharply before its purchase orders were completed.

So the food processing company would go long wheat futures contracts — thus taking a bullish position, the opposite of what the farmer did — to hedge against the price of wheat rising rather than falling. This reflects the food company’s business risk as a buyer of wheat, versus the farmer’s risk as a seller.

In the stock market, the term “hedge fund” originally implied the hedging of market risks, which goes back to “insurance” against the impact of undesirable price movements. But rather than using futures contracts, for hedge funds this was done via bearish stock positions to offset the downside risk of bullish ones.

If a hedge fund manager wanted to invest in Ford, but not the rest of the auto industry, for example, they might take a bullish position in Ford, but then take a bearish position in other automakers. This would reduce the overall market exposure risk of being long Ford. A bearish automaker position might also let the hedge fund manager take his long Ford position in far larger size, because the downside risk is less.

Another reason hedge fund managers like bearish positions is because they can lower the “beta” of a portfolio, which reduces market risk and lessens volatility.

In the stock market, beta is a measure of two things: How volatile a stock is, and how correlated the stock is to the larger market.

Beta is a mathematical calculation based on correlation and historical price movement, and as such, it also applies to instruments other than stocks: ETFs, options, futures, indexes and so on. But the most popular use of beta is applying it to stocks and, at a higher level, applying it to entire stock portfolios.

In general terms, if a stock has a beta of 1.0, that means it is has about the same level of risk and volatility as the market. So if the S&P 500 rose 10%, a stock with a beta of 1.0 would also be expected, in general terms, to rise 10%.

If a stock has a beta of 1.5, that means it is 50% more volatile than the market on average. If the S&P rises 10%, a 1.5 beta stock could be expected to rise 15% (a multiple of 1.5X).

It also holds in the downward direction: If the S&P falls 10%, a stock with a beta of 1.5 would be expected to fall 15% on average.

A beta between 0 and 1 means less risk than the market. So a stock with a beta of 0.5 would only move half as much (50% as much) as the broader market.

It is also possible to have a negative beta, where the value is between 0 and negative 1. This happens when the correlation is negative.

For example TBF, the ProShares Short Treasury ETF, will have a negative beta relative to its treasury bond benchmark, because TBF falls when treasury prices rise (and rises when treasury prices fall).

Beta can also be calculated for an entire portfolio. This is done simply by calculating the beta for each position in the portfolio, adjusting it for position size, and then taking the net of all the betas together.

So a stock portfolio with a beta of 1.5 would be 50% more volatile than the market on the whole, while a stock portfolio with a beta of 0.5 would be half as risky as the market.

These are just mathematical estimates, of course, but they are based on logical calculations using historical data. (Because the future is not yet written, the past is what we have to go on — while always remembering that the past is a guide, not a guarantee.)

For most hedge fund managers, the big goal is delivering steady investment returns with less volatility than the market. This is where bearish positions in a portfolio can pay off.

A bearish position in a portfolio — whether it is a short position in a stock or ETF, a long-dated put option, or something else — will have a negative beta by definition. It is expected to profit if the market declines.

This in turn means that bearish positions mixed in with bullish ones tend to lower the overall beta of a portfolio, which lowers the expected amount of overall volatility and risk. The results of this can be quite valuable.

For example, say that two portfolios both deliver 15% gains over 12 months, but portfolio A has lower beta, and manages to deliver those 15% gains with half the volatility of portfolio B.

In market terms, portfolio A would be considered more efficient, and investors in portfolio A would have an easier time sleeping at night. If these results were replicated over time, the money manager running portfolio A would have a lot more success than the one running portfolio B.

The impact on total portfolio volatility, through the lowering of beta, explains why bearish positions in a portfolio can make it easier to hold bullish positions.

In market environments that are volatile or risky, it can be good to have positions that will profit even if the market falls. And even in markets that are calm and bullish, delivering returns with lower beta can mean better sleep at night.

In TradeStops, you can use our tracking tools and market indicators not just to follow industries and stocks you are bullish on, but also to track industries and stocks you are bearish on.

This creates the opportunity to add bearish positions to the portfolio, which can improve results in the manner just explained. And if you don’t like shorting stocks or ETFs — which is completely understandable — there are many ways bearish positions can be constructed more safely, like the use of long-dated put options or inverse ETFs.

To see this in action, try making a copy of your existing portfolio in TradeStops, saving it as a new watch portfolio. Then add some bearish positions and measure the overall portfolio volatility using the Portfolio Volatility Quotient (PVQ) Analyzer. Then, compare the watch list PVQ with that of your investment portfolio and you should see a drop in overall volatility with the bearish positions added. (Hint: You can also use the Position Size Calculator to ensure you’re right-sizing your bearish positions, too).

One secret hedge fund managers know is that, while bearish positions are sometimes considered exotic, an investor with the right tools can use them to reduce portfolio risk and lower their overall volatility.

Richard Smith
Richard Smith, Ph.D.
CEO & Founder, TradeSmith