What is Hedging ?

by khalid on 08/11/2011 · 0 comments

Hedging is called the protecting your hard earned money from the market fluctuations. It reduces risks and threats. It is a safety practice and is done by taking a position in the futures market that is opposite to the one in the physical market with the objective of reducing or limiting risks associated with price changes.

An example of a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations.

Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the hedge).

The futures market also has substantial participation by speculators who take positions based on the price movement and bet upon it. Also, there are arbitrageurs who use this market to pocket profits whenever there are inefficiencies in the prices. However, they ensure that the prices of spot and futures remain correlated.

Hedging a stock price
A stock trader believes that the stock price of Company A will rise over the next month, due to the company’s new and efficient method of producing widgets. He wants to buy Company A shares to profit from their expected price increase. But Company A is part of the highly volatile widget industry. If the trader simply bought the shares based on his belief that the Company A shares were underpriced, the trade would be a speculation.
Since the trader is interested in the company, rather than the industry, he wants to hedge out the industry risk by short selling an equal value (number of shares × price) of the shares of Company A’s direct competitor, Company B.
The first day the trader’s portfolio is:
Long 1,000 shares of Company A at $1 each
Short 500 shares of Company B at $2 each
(Notice that the trader has sold short the same value of shares)
If the trader was able to short sell an asset whose price had a mathematically defined relation with Company A’s stock price (for example a put option on Company A shares), the trade might be essentially riskless. In this case, the risk would be limited to the put option’s premium.
On the second day, a favorable news story about the widgets industry is published and the value of all widgets stock goes up. Company A, however, because it is a stronger company, increases by 10%, while Company B increases by just 5%:

Long 1,000 shares of Company A at $1.10 each: $100 gain
Short 500 shares of Company B at $2.10 each: $50 loss
(In a short position, the investor loses money when the price goes up.)

The trader might regret the hedge on day two, since it reduced the profits on the Company A position. But on the third day, an unfavorable news story is published about the health effects of widgets, and all widgets stocks crash: 50% is wiped off the value of the widgets industry in the course of a few hours. Nevertheless, since Company A is the better company, it suffers less than Company B:

Value of long position (Company A):
Day 1: $1,000
Day 2: $1,100
Day 3: $550 => ($1,000 − $550) = $450 loss

Value of short position (Company B):
Day 1: −$1,000
Day 2: −$1,050
Day 3: −$525 => ($1,000 − $525) = $475 profit

Without the hedge, the trader would have lost $450 (or $900 if the trader took the $1,000 he has used in short selling Company B’s shares to buy Company A’s shares as well). But the hedge – the short sale of Company B – gives a profit of $475, for a net profit of $25 during a dramatic market collapse.

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