Hedging is a way of reducing some of the risk involved in holding an investment.
There are many different risks against which one can hedge and many different methods of hedging.
When someone mentions hedging, think of insurance.
A hedge is just a way of insuring an investment against risk.
Consider a simple case.
Much of the risk in holding any particular stock is market risk; i.e. if the market falls sharply, chances are that any particular stock will fall too.
So if you own a stock with good prospects but you think the stock market in general is overpriced, you may be well advised to hedge your position.
There are many ways of hedging against market risk.
The simplest, but most expensive method, is to buy a put option for the stock you own.
It’s most expensive because you’re buying insurance not only against market risk but against the risk of the specific security as well.
You can buy a put option on the market which will cover general market declines and/or you can hedge by selling financial futures.
The best (and cheapest) hedge is to sell short the stock of a competitor to the company whose stock you hold.
For example, if you like X company and think they will eat Y’s lunch, buy X and short Y.
No matter which way the market as a whole goes, the offsetting positions hedge away the market risk.
You make money as long as you’re right about the relative competitive positions of the two companies, and it doesn’t matter whether the market zooms or crashes.
If you’re trying to hedge an entire portfolio, futures are probably the cheapest way to do so.
But keep in mind the following points.
The efficiency of the hedge is strongly dependent on your estimate of the correlation between your high-beta portfolio and the broad market index.
If the market goes up, you may need to advance more margin to cover your short position, and will not be able to use your stocks to cover the margin calls.
If the market moves up, you will not participate in the rally, because by intention, you”ve set up your futures position as a complete hedge.
Another technique would be to sell covered calls on your stocks.
You won’t be completely covered against major market drops, but will have some protection and…
Some possibility of participating in a rally!