What Is a Hedge in the Stock Market?
Hedging stock is an important tool for diversifying risk by pairing the stock owned (the long position) with an appropriate short position. Thus, hedging is not about absolute return but rather the relative advantage one stock or commodity has over another. There are many ways to hedge so that profit is made not just on the long position but on the short position, as well. In addition, investors often will find cross market-hedging--using a long stock position and short a futures or commodity contract of use. Hedging is for sophisticated investors only.
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What is a Stock Hedge ?
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A stock hedge attempts to offset the the risk of a decline in an asset by shorting a similar stock that is not expected to perform as well as stock purchased. Savvy investors seeking to maximize return while minimizing risk commonly use hedges. Maximizing relative return is measured by a statistic called alpha. Measuring relative risk in stocks is measured by a statistic called beta.
Hedging Through Stock Options
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If an investor buys a stock at $52 expecting it to rise to $60, he can limit his risk by buying a put option at a strike price of $50. A put option seller pays a small fee (assume $1 for this illustration) for the right to sell the stock to another investor if the stock drops to $50 or lower. The investor's effective cost is then $53. The put seller's cost is $49. If the stock reaches $60, the investor makes $7 (also called points). The investor has hedged his risk at $50 for the price of 1 point. If the stock drops to $45, the put buyer has only lost 3 (52 +1 -50) points. Thus the anticipated risk to reward ratio is 7 to 3, or 233 percent.
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Hedges in the ETF Market
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Hedges can be made in the commodity markets as well as in the stock markets. Hedges are often imprecise or just wrong. Wrong judgments can leave the investor with two securities moving against the trading positions the investor entered into. For example, a trader hedges a gold position in an exchange traded fund (an ETF is a fund that represents a certain type of asset but is traded as a stock on an exchange) by shorting a silver ETF. This indicates that the trader expects gold to outperform silver on a relative basis. Instead market news causes silver demand to rise while world tensions ease, causing gold to drop in price. Now the trader has given up profits in gold and must cover his short position by buying the silver fund at a higher price than that which he shorted or sold the metal.
Choosing a the Proper Hedge Requires Careful Study
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Institutional traders hedge 30-year mortgage bonds with 10-year U.S. Treasury bonds. These can be purchased as ETFs. It would seem logical that the mortgage bond fund should be hedged with a 30-year government bond ETF. However, traders understand that most people only live in their homes an average of seven and a half years. Thus, the appropriate hedge is one of shorter duration.
Hedging Stocks with a Stock Index Fund
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Hedging a technology company like Hewlett Packard (a stock that trades on the New York Stock Exchange--symbol HPQ) requires the investor not use the Dow Jones Index hedge (NYSE symbol DIA) but that of a hedge more representative of technology. Thus, the investor should short the NASDAQ index (NASDAQ symbol QQQQ). If the investor so desired, he could obtain the same hedge by using the futures market to hedge an appropriate number of futures contracts.
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