Hedging in financial terms is defined as entering transactions that will protect against loss through a compensatory price movement.
Hedging is what seperates a professional from an amateur trader. Hedging is the reason why so many professionals are able to
survive and profit from stock and option trading for decades. So what exactly is hedging? Is hedging something only professionals
like Market Makers can do?
Hedging comes from the term "to Hedge" and is any technique designed to reduce or eliminate financial risk. Hedging is the calculated installation of protection and insurance into a portfolio in order to offset any unfavorable moves.
In fact, hedging is not restricted only to financial risks. Hedging is in all aspects of our lives; We buy insurance to hedge against the risk of unexpected medical expenses. We prepare fire extinguishers to hedge against the risk of fire and we sign contracts in business to hedge against the risk of non-performance. Hence, hedging is the art of offsetting risks.
In the simplest form, hedging is simply buying a stock which will rise as much as the current stocks would fall. If you are holding
XYZ stocks which is already profiting and you want to protect that profit if XYZ should suddenly fall, then you would buy ABC stock, which
rises $1 if XYZ drops $1. In that way, if XYZ company falls by $1, your ABC company stocks would rise by $1, thereby offsetting the loss in
|Hedging Example : Assuming you own 100 shares of QQQQ @ $44 and you wish to hedge against downside risk using stock options. You would buy 1 contract of QQQQ $44 put options which will rise in value by $1 upon expiration for every $1 decline in the price of QQQQ. The price of this "insurance" would be the price you pay for the put options.
Read about How Stocks Can Be Riskier Than Options.
Hedging a portfolio of stocks is easy and convenient using stock options. Here are some popular methods:
Protective Puts : Hedging against a drop in the underlying stock using put options. If the stock drops, the gain in the put options offsets the loss in the stock.
Covered Calls : Hedging against a small drop in the underlying stock by selling call options. The premium recieved from the sale of call options serves to buffer against a corresponding drop in the underlying stock.
Option traders hedging a portfolio of stock options or hedging an option position in an option trading strategy, needs to consider
4 forms of risk. Directional risk (delta), how directional risk will change with stock price changes (gamma), volatility risk
and time decay risk (theta). Yes, these are the Option Greeks.
These risks are factors that influences the value of a stock option and measured by the Option Greeks.
Option traders do not normally perform hedging for interest rate risk (
rho) as its impact is very small. Hedging a stock option portfolio requires understanding of
what the biggest risk in that portfolio is. If time decay is of concern, then
theta neutral hedging should be used. If a drop in the value of the underlying stock is of greatest concern, then
delta neutral hedging should be used. All these hedging are done in accordance to the hedge ratio.
Hedging directional risk takes on one of two techniques; Delta Neutral Hedging or Contract Neutral Hedging. Hedging the other 3 forms of risk requires a technique called "Spreading". A popular options strategy that makes use of hedging is the Stock Replacement Strategy.
Some stock or option traders regard themselves as long term investors who buy and hold for the long term in order to ride an overall
long term gain in the stock markets, ignoring short term and mid term fluctuations. These traders completely ignore hedging
under the false sense of security that the stock markets will rise over time without fail. While that may be true over the long term of about
20 to 30 years, short term ditches of up to a couple of years do happen and destroys portfolios that are not hedged. Not hedging in this
sense is akin to not buying accident insurance just because you always cross the road obeying traffic rules. Does that
guarantee that unforeseen circumstances won't happen?
Sometimes, the cost of hedging just doesn't justify the assessed downside risk of a portfolio. We don't live in an ideal world where it costs nothing to execute trades. Hedging involves executing more trades, which costs more money. If a portfolio is assessed to have a $10,000 downside risk, you would not want to incur a hedging cost of $20,000 in order to hedge that portfolio, right? However, if the assessed downside risk is $100,000, a hedging cost of $20,000 would more than justify putting on a hedge.
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