Simple Hedging - How does it work?

Discussion in 'Trading' started by StepByStep, Aug 18, 2011.

  1. I'm not sure I 100% understand how hedging works / the mechanics. Doesn't it just make everything break even?

    Without getting into options or other derivatives, just talking stocks.. How should I hedge a position?

    Right now I am long an electronics company.. I am also long an ETF that is the inverse of the market index. So... the market goes down, my inverse market index ETF is going up.. So I'm making money there... Of course, my electronics company is losing me money.. Overall, it's more or less a wash / break even..

    So, how is this supposed to work? Why is hedging a good idea and not just a way to end up break even all the time?

    What is the general-case timing for exiting the position and the hedge to make this work properly?
     
  2. rmorse

    rmorse ET Sponsor

    Your example, was not simple. So let's make it more simple. You like a stock and want to get long. It's a tech company with an event coming up and you feel that will be a catalyst for the next six months and that stock will out perform. You find 4 or 5 other stock you want to get long for the same period for whatever reason. Now you have a choice. Let's say the portfolio you're buying is $100,000 of those stocks. You can be long the portfolio of $100K worth of stocks, that you feel will outperform the market with no hedge, or hedge. If you don't hedge out market risk, and the market drops 10% over the next 6 months and your portfolio drops 2%, your were right but still lost money. If you choice to hedge out a part or all the market risk by shorting any or all the value of the $100K with SPY, you're left with Alpha risk. You're left with your strategy of picking stocks that will outperform "the market."

    I hope this helps. Most hedging does not eliminate risk, only transfers or lowers one type of risk for another.