To fully understand and implement an effective hedging strategy, you must understand a few key aspects: derivatives (futures and options), forwards (for FX), and the inputs of your investment tool (stock, commodity, etc.). This write-up is going to simply tell you what hedging is and give you the most basic example.
Hedging is a strategy that helps an investor reduce the risk that he or she takes on in an investment. It is not something that can protect you from all losses, but it can help mitigate losses. Logically, the less risk you, as the investor, want to assume, the more expensive your hedging strategy is going to be.
Your probably thinking: “I like high risk/return. Why would I bother hedging –it just takes away from my return?” In fact, it is usually investors that trade in the most risky investments that will be heavily hedging downside. Hedging allows an investor to take on more volatility with limited downside. Some alternative management firms refer to hedging as covering a trade.
Hedging in its most basic form is applied by purchasing an option on a purchased or shorted investment that will give you the option (but does not require you) to liquidate your investment at a predetermined price if market moves against you. The market price minus your contracted price should be equal to your downside risk tolerance. A general rule of standard for speculation is +/-10% off of the market depending on the beta.
If the market moves in your favor, your profits will equal your capital gains and dividends, minus your options pricing. If the market moves falls below your contracted price, you will have the option to liquidate your investment at your contracted price as long as this move happens before your option expires.
In your trading, let’s say that you bought 100 stares of SPWR at $12.47/share on 2/16/13. Now, your uncertain of your investment, and you know that solar power companies have been known to underperform, but you felt that you could make money in on a one month window but want to have the option to liquidate of your investment at no less then $11.00/share. You would purchase ONE contract (100 shares/contact generally) with SPWR as your underlying, a strike price of $11.00, and an expiration date of Mar. 16, 2013. This particular strategy will ensure that your total losses never cost you more than 11.9% of your investment.
In my next article, I will talk more about how to hedge risk and what it means to be covered at certain prices and extending your options. I will also talk a little more about where you can begin with your personal option trading outside of hedging, and how you can use options to speculate and make money.
Author: Cody West
Boston University Trading Club