why people hedge?

Discussion in 'Risk Management' started by traderzhangSan, Jun 19, 2010.

  1. It always puzzled me when people say they hedged their positions.
    I mean why bother? if you really want to hedge, just close the positions. that is the best hedge.

    any idea?
  2. To reduce risk without decreasing return, instead of reducing risk AND return. There are other reasons. Also not every hedge does what the hedger wants to do. Zero correlation is useful.
  3. manustone


    Hi Trading Journals!
    can you make an example about hedge not really working?
    Mee too I see hedging like a "Closing a position with profit/return" i.e. lock the profit/return against any change in price.
    Do you think it is too simplicistic way of seeing heding?
  4. moarla


    A nice hedge would be:

    holding physical Gold bars/coins and not willing to let em go
    hedging with futures against price going down, when you see that the price is going down...
  5. Hedgers are looking for some measure of price certainty. Commodity hedgers – people who trade agricultural products, energy products or metals, for example – typically are involved in commercial interests that will either produce, process or utilize the commodity they are trading. Hedgers of financial futures are typically in businesses that depend upon interest rates, foreign exchange rates, or stock index levels, such as banking or pension fund management.

    Cattle ranchers, for example, may fear that cattle prices will decline before they bring their animals to market. To protect themselves, they decide to sell futures on live cattle that will expire at approximately the same time they expect to deliver their cattle to the market, and at the price they are hoping to get in the cash market. If cattle prices do go down, the ranchers can still make money on their future’s positions, which will hopefully offset the reduced price they receive for their cattle.

    Example -

    June 1st - (Cash Market) Cattle is $0.87/lb.
    June 1st - (Futures Market) Rancher sells one CME October Live Cattle futures contract at $0.89/lb*.

    October 1st - (Cash Market) Cattle prices have dropped to $0.77/lb. Rancher sells cattle at market price of $0.77/lb.
    October 1st - (Futures Market) Rancher buys back the October contract at $0.79/lb.

    Outcome - (Cash Market) Rancher receives $0.10/lb. less than desired price.
    Outcome - (Futures Market) Rancher sells futures contract at gain of $0.10/lb.

    Calculations - (Cash Market) Price rancher wanted: $0.87/lb. x 40,000 lbs. = $34,800 - Actual price received: $0.77/lb. x 40,000 = $30,800 - Actual price received is $4,000 less than the rancher wanted.
    Calculations - (Futures Market) Rancher sold futures at $0.89/lb. Rancher bought back futures at $0.79/lb. - Futures profit = $0.10 x 40,000 = $4,000

    Net Result - Rancher’s loss in cash market is offset by gain in futures market. Hedging strategy succeeded.

    The futures price is slightly higher than the cash price to accommodate costs of shipping and delivery of cattle.
  6. You are short a portfolio of 100 small and midcap stocks.
    Every 1% the S&P goes up, your portfolio loses 0.5%. You see why it would make sense to hedge with/ be long SPY or ES.
    This makes even more sense if every 1% the S&P goes down your portfolio goes up 1.5%
  7. akin to a dulcet bush, abundant silky, wavy foliage but way shy of the Lacondan Jungle, yet being able to subtly hint re: the waft and splendor of the cave that it conceals.
  8. snoopyln


    Well this question has many answers but it's best to illustrate with an example:

    Suppose you were really bullish about AAPL but your view is actually not that simplistic - are you buying AAPL because you like it more than other tech stocks? Are you buying it because you like it more than any stock in the S&P 500? Are you buying it because you like it's risk/return ratio over AAPL bonds, AAPL convertibles, AAPL options, etc.

    For simplicity reasons, I'm assuming you buy AAPL b/c you think it's a good stock relative to other stocks. You could be absolutely right about this and still lose money if AAPL went down 5% and the S&P 500 went down 10% and the reason you lost money on this trade is because you exposed yourself to systematic risk (let's say NYC gets nuked, this should have no effect on AAPL stock directly but it drags the whole market down including AAPL). So buy just buying AAPL stock and not shorting the S&P 500 to go with it, you did not trade the view you intended to trade and you lost 5% b/c you exposed yourself to the broad overall market but if you hedged properly, you would have made 10% on shorting the S&P 500 and made lost 5% buying AAPL with a net gain of 5%. This was your intended trade to begin with - this is a very simplistic example and explanation as to why people hedge so you can design/fine tune trades to exactly your risk/return profile.

    Being a professional trader, you need to understand all the risks you take when laying on a trade and this is the simplest among them. Markets are very correlated nowadays - you have to know what risks you take on and how to hedge them out to be a successful trader. Btw, you owe me lunch for sharing this information with you because I should be picking you off =)
  9. Is this a trick question?

    You hedge to isolate the factors you are betting on, and reduce the price impact of factors you don't want to bet on. For example, a classic long/short hedge fund wants to bet on stock A vs stock B, not on overall market direction. How would it do that if it just stayed in cash?