These days, I spend quite a lot of time teaching people about markets and trading and mentoring them as they start to invest their own money. Everyone is different in terms of their level of knowledge and their ability to grasp complex concepts quickly when we first meet, but there are some subjects that I cover where it seems almost nobody fully understands what is involved. One such subject is hedging. Even those who know what it means, in theory, have problems understanding its practical applications, and most think of it as a tool to be used in the context of short-term trades only.
That is certainly true with some hedges, usually of the leveraged variety. Buying a 3x bear S&P ETF or a VIX tracking product to protect your portfolio a bit when there is trouble looming is not a bad tactic, but the nature of those kinds of products makes it important that you use them only short term. There are, however, hedges you can use to protect against a specific risk to a long-term position or portfolio weighting.
I am sure that if you are reading this, you have an interest in energy investing, which in most cases means that you have a portfolio that most would consider to be overweight exposure to oil. That is probably by design and based on your feeling that, no matter what some might say, the world still needs oil and there are therefore good profits to be made in the industry. That is true, but it does come with risks.
Most notable among those risks is the rise of…
These days, I spend quite a lot of time teaching people about markets and trading and mentoring them as they start to invest their own money. Everyone is different in terms of their level of knowledge and their ability to grasp complex concepts quickly when we first meet, but there are some subjects that I cover where it seems almost nobody fully understands what is involved. One such subject is hedging. Even those who know what it means, in theory, have problems understanding its practical applications, and most think of it as a tool to be used in the context of short-term trades only.
That is certainly true with some hedges, usually of the leveraged variety. Buying a 3x bear S&P ETF or a VIX tracking product to protect your portfolio a bit when there is trouble looming is not a bad tactic, but the nature of those kinds of products makes it important that you use them only short term. There are, however, hedges you can use to protect against a specific risk to a long-term position or portfolio weighting.
I am sure that if you are reading this, you have an interest in energy investing, which in most cases means that you have a portfolio that most would consider to be overweight exposure to oil. That is probably by design and based on your feeling that, no matter what some might say, the world still needs oil and there are therefore good profits to be made in the industry. That is true, but it does come with risks.
Most notable among those risks is the rise of electronic vehicles (EVs). The vast majority of the world's oil production is used to make fuel for vehicles and the increasing adoption of EVs makes a long-term reduction in demand for oil-based fuels seem inevitable. I'm sure you know that and have considered it, but have you done anything about it? For most people, the answer to that question is no. There are, however, ways of hedging that risk while still benefitting from any gains that may accrue in your oil industry stocks.
When pressed, people usually think of a hedge as basically a trade in the opposite direction to the one that you are trying to protect. Thus, an inverse, leveraged index ETF is bought to protect a portfolio, because it goes up when the market, and therefore the majority of your portfolio, goes down. The problem is that that is essentially a zero-sum game. One trade loses as the other gains, so all that kind of hedge does is effectively reduce the size of your position. There is a much easier way of doing that, of courseâ¦you just sell some of your stock. However, if you have a long-term belief in your investment and don't want to do that, you take out a position as a hedge when you see the possibility of short-term volatility.
But what about long-term protection? It makes no sense if that is your aim to just take a position that opposes your portfolio because, as I just said, there are easier and less expensive ways to reduce your overall position size. In that case, you should look for something that can benefit from what you see as a risk, but where there is a good chance that both your core positions and your hedge can show profit over time. In the case of EVs as a risk to investments in oil companies, there are a number of ways to do that.
For me, it makes most sense to do it by a supplier to the industry, a point I have made here before that I call a "picks and shovels" approach, and the most appealing supply area in the EV space is battery makers. Whoever ends up dominating the EV market, or even if no one does and the big auto manufacturers simply switch over time to increased EV production, battery demand will increase massively over the next decade or two. A company like QuantumScape (QS) can benefit from that.
QS, like ORA, a stock I wrote about last week, got caught up in the whole meme stock thing at the end of 2020, when it jumped from around $11 to over $132 in just a couple of months before dropping back to earth nearly as quickly. After all the excitement died down, it settled at a "neutral" level just above $20 for a while, then dropped further to hit a low of $5.11 at the end of last year, when stocks with potential rather than profits were being punished.
That mood has changed this year, though, and in the short-term QS now looks to be headed back to its average price throughout last year. Buying into that momentum makes sense right now as a starting point, although there are significant risks. QuantumScape is a "pre-revenue" venture, which is a polite way of saying the company has never made a dime. However, they did ship prototypes of their batteries to auto manufacturers last year. That suggests that production and revenue are not too far away, and the prototypes were reportedly well received. And, with some big money backers like Bill Gates and Volkswagen (VWAGY) already invested, they have a better chance than most of getting to that point.
Despite that, as a pre-revenue venture QS is risky, no matter who is involved. So, to those who have a very narrow view of a hedge, it might seem crazy. If you define a hedge as something to reduce risk overall, then buying it makes no sense. If, however, you understand that a hedge is about targeting a specific risk, then adding QS to an oil-heavy portfolio makes perfect sense. If the risk to oil as vehicle fuel intensifies, then the potential of a company like QuantumScape will have massive value, and even a small investment now could provide enough upside to offset losses in a relatively large portfolio. However, it could well appreciate significantly even as oil companies continue to prosper. That is what I call a good hedge.
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