Hedging is the act of taking out an opposing position to one or more existing positions that will offset these positions in the event of a loss.
A hedging position will almost invariably be smaller than the main position, but a hedge can sometimes make a failed trade profitable if the hedging position was acquired on favorable terms.
Part of the explosive rise in the popularity of derivatives is the result of their suitability for hedging positions.
An Example of Hedging
Suppose that a trader opens a long position in the shares of Company A worth $1,000 at 50$ per share. The trader believes that the stock is currently undervalued and expects the value to steadily rise over the next earnings season.
However, the company is currently facing some legal headwinds that are expected to blow over, but could be costly in the event of the court ruling against them.
In this example, the trader purchases put options for Company A shares worth $50 in premiums with a strike price of $45 per share. If the price of the stock increases more than 5% over the lifetime of the put options, then the $50 in premiums paid out to hedge the position will be covered by the returns from the shares.
If the price of the shares fall below the $45 strike price of the put options, then the increased value of the put options begins to offset the loss in value for the shares (minus the sunk cost of the premiums paid).
This is one of the simplest examples of a hedging strategy, but they can be far more complex, or even far more subtle.
For example, the trader may buy call options on the shares of Company B, which is in direct competition with Company A. If Company A fails to get one or more key contracts, then those contracts will likely go to Company B instead.
The result being a decrease in the share price of Company A and an increase in the share price, and call option price, of Company B. Once again the value of the hedging position offsets some or all of the loss from the decline in value of the main position.
The key to any hedging strategy is that the value of the main position and the value of the hedging positions are inversely correlated, so any loss in the value of the main position leads to some gain in the value of the hedging position.
Hedging and Trading
Most day traders will not be exposed to the market long enough to require hedging in the classical sense.
However, many highly successful day trading strategies, particularly in the market for derivatives, are based on the concept of hedging. These day trading strategies use offsetting positions and windows of profitability to make extremely precise short term bets that can pay off tremendously in the very near term when successful.
For example, a day trader may purchase derivatives to construct a position that only pays out when the price of a share increases from $40 to $45 per share in a one day period, facing mounting losses as it increases past the $45 point or decreasing below the $40.
Since the day trader is taking such a short term position, less than one day, they can be reasonably assured that any price change will be small enough to stay within this window, thus allowing them to profit far more from a long position than they would by simply purchasing shares and holding them for the day.
Hedging is a key feature of the contemporary financial landscape.
From traders protecting relatively small individual positions to institutions developing broadly diversified portfolios to derivatives traders constructing highly sophisticated and complex positions, the principle of hedging drives many of the actions that are taken in today’s markets.
Day traders who understand the principle of hedging and how it drives market behavior can make successful trades by predicting the hedging activity of other market participants.
What may be a small price to pay for insurance on a position for a large institution could represent an enormous payday for a day trader who has positioned himself to profit from this hedging action.