How to Hedge in Investments
Look for the classic hedge while trading stock., Determine your position., Identify the market sector., Determine the market value of your position., Watch the fun begin.
Step-by-Step Guide
-
Step 1: Look for the classic hedge while trading stock.
It's often called a "pairs trade," as it seeks to reduce risk by taking an opposite position in a second security within the same sector. -
Step 2: Determine your position.
If you are long a stock and you want to reduce downside risk, you will have to short another stock.
If you are short a stock, and you want to reduce upside risk, you will have to go long on another stock. , If you are long a position in Exxon (ticker:
XOM), you will want to choose a competitor in that same sector, such as Shell (RDS/A) or Conoco Phillips (COP).
This is to protect yourself from industry risk, as most of the stocks of one sector will follow each other in large market movements.
If you choose a stock from a different sector, the reliability of your hedge will be reduced as some sectors are negatively correlative (as seen in gold stocks recently). , Suppose you are long 25 shares of Conoco, which is trading at $40, so your position size is $1,000.
You want to protect this $1,000, so you decide to choose Shell as your hedge, which is trading at $50.
Since you want to hedge $1,000 in long stocks, you will want to go short $1,000, so you would sell short 20 shares of Shell.
Conoco: $40.00 * 25 = $1,000 Shell: $50.00 *(-20) = $(-1,000) Total Profit/(Loss): $0 , Continuing with this example, pretend, the next day the government cuts the oil tax, and both companies jump up.
You were right on your pick of Conoco performing better, as it jumps up 10%, while Shell goes up 5%.
Conoco: $44.00 * 25 = $1,100
--> $100 profit Shell: $52.50 *(-20) = $(-1,050)
--> (-$50) loss Total Profit/(Loss): $50 One week later, there is a market crash.
Conoco, being (in this scenario) the more resilient company (which you spotted in your financial analysis) drops only 30% while Shell drops 40%.
Conoco: $30.80 * 25 = $770
--> (-$230) loss Shell: $31.50 *(-20) = (-$630)
--> $370 profit Total Profit/(Loss): $140 By using the classic "pairs trade" hedge, you manage to reduce your risk and walk away from what would have been a $230 loss with a $370 profit.
Investing isn't always this easy, however.
If Conoco had been the lagging company, you would have walked away with a loss.
The "pairs trade" is not a perfect hedge.
If it were, everyone would use it. -
Step 3: Identify the market sector.
-
Step 4: Determine the market value of your position.
-
Step 5: Watch the fun begin.
Detailed Guide
It's often called a "pairs trade," as it seeks to reduce risk by taking an opposite position in a second security within the same sector.
If you are long a stock and you want to reduce downside risk, you will have to short another stock.
If you are short a stock, and you want to reduce upside risk, you will have to go long on another stock. , If you are long a position in Exxon (ticker:
XOM), you will want to choose a competitor in that same sector, such as Shell (RDS/A) or Conoco Phillips (COP).
This is to protect yourself from industry risk, as most of the stocks of one sector will follow each other in large market movements.
If you choose a stock from a different sector, the reliability of your hedge will be reduced as some sectors are negatively correlative (as seen in gold stocks recently). , Suppose you are long 25 shares of Conoco, which is trading at $40, so your position size is $1,000.
You want to protect this $1,000, so you decide to choose Shell as your hedge, which is trading at $50.
Since you want to hedge $1,000 in long stocks, you will want to go short $1,000, so you would sell short 20 shares of Shell.
Conoco: $40.00 * 25 = $1,000 Shell: $50.00 *(-20) = $(-1,000) Total Profit/(Loss): $0 , Continuing with this example, pretend, the next day the government cuts the oil tax, and both companies jump up.
You were right on your pick of Conoco performing better, as it jumps up 10%, while Shell goes up 5%.
Conoco: $44.00 * 25 = $1,100
--> $100 profit Shell: $52.50 *(-20) = $(-1,050)
--> (-$50) loss Total Profit/(Loss): $50 One week later, there is a market crash.
Conoco, being (in this scenario) the more resilient company (which you spotted in your financial analysis) drops only 30% while Shell drops 40%.
Conoco: $30.80 * 25 = $770
--> (-$230) loss Shell: $31.50 *(-20) = (-$630)
--> $370 profit Total Profit/(Loss): $140 By using the classic "pairs trade" hedge, you manage to reduce your risk and walk away from what would have been a $230 loss with a $370 profit.
Investing isn't always this easy, however.
If Conoco had been the lagging company, you would have walked away with a loss.
The "pairs trade" is not a perfect hedge.
If it were, everyone would use it.
About the Author
Tyler Rodriguez
Experienced content creator specializing in organization guides and tutorials.
Rate This Guide
How helpful was this guide? Click to rate: