I don't understand the purpose of "hedging"

Discussion in 'Trading' started by IronFist, Oct 18, 2006.

  1. or maybe I have the concept wrong.

    I was reading something talking about taking opposite positions at the same time and referring to that as hedging.

    Wouldn't that be the same as NOT being in the market at all? Why put forth the extra effort of being in the market when you're not going to profit either way?

    Or do I have this completely wrong?
  2. AaronCapps

    AaronCapps Global Futures

    the classic idea of hedging was for farmers and producers that wanting to lock in current prices of their product. Hedging, technically is not to make a profit or risk a loss. Although because the hedge may strengthen or weaken, you can have small variations in price.

    Now a days, more people like the idea of doing like to like hedges to either lock in profit or loss during large market announcements as a way to hold on to their original entryprice which may have some psychological importance to them.

    some like to do this type of hedging as a style of trading, where they will take profits in one of the accounts, then maybe average in on the second account and exit on a retracement.
  3. In a "perfect hedge" you have no market exposure. Hedging is mostly to eliminate certain types of risk. For example, you could be long one of the dow components and short the dow itself (futures, options or etf) and that would in theory remove "market risk", ie the risk of the entire market tanking. At that point your "trade" is essentially trying to capitalize on the percieved difference of value of the stock's price vs what you think it is, and contains no market risk.

  4. To expand on Aaron's post, hedging existed to ensure someone who MUST be in the market with downside exposure (i.e. farmers with crops) is protected in the event that downside exposure occurs.

    The farmer must plant and produce his crops - he just wants to make sure he doesn't completely lose all his money if the market for his crops is substantially depressed when they are harvested. Same thing for the buyers of those crops.

    Now, these days of course, hedging is much more/less than that. It's an out of date term for how it's being applied (mostly).
  5. THAT makes a whole lot more sense.
  6. Purpose of "hedging" - My guess is we simply don't want the potential risk would be beyond our desired level.
  7. The basics of hedging are this. You try to limit or eliminate "market movement risk" by being (for example) Long 2,000 of stock "A" (the stronger stock based on your criteria), and short stock "B" (the weaker stock)...you then look back over a year, 5 years, etc., and see if their prices have criss crossed over time. If Stock B is $3 higher than Stock A, you would short B and Buy A...if the prices crossed, you would make $3.00.

    Another type of hedging is selling futures contracts at a Premium to Fair Value, and buying all the underlying securities...and then (often same day), you reverse the trade at a profit by buying the futures at a Discount, and selling back the equities (I'm using the S&P 500 or Emini's in this example).

    Either example greatly reduces market risk. With the pairs of stocks, you collect interest on the short side (if you're a Prop trader, not generally given to retail traders). If you are using the futures, you have a mathematical edge based on interest rates (cost of carry).

    If you would like more detailed information, send me an email to; don@stocktrading.com

    All the best,