Jan

30

Basic Hedging Techniques

January 30, 2008 | Leave a Comment

With all this talk of hedging, it might help to provide a definition of what is meant so those who are unaware can get up to speed. Hedging is simply an investment strategy that is designed to offset investment risk. Depending on the type of investing, various hedge strategies can be employed. In theory, a perfect hedge is one that offsets gains and losses, therefore being completely neutral.    

Direct Hedge: This is accomplished by hedging one asset, such as common stock, with another asset that shares similar price movements; trades in a similar fashion. An example: hedging a common stock position with call options.    

Cross Hedge: Involves hedging an instrument with an unlike instrument. An example of a strategy that failed in the crash of 1987 will exemplify the concept. This involved buying (long) preferred stocks and hedging the position with Treasury futures. Interest rates drive Treasury futures, and there are times when these two instruments track one another — about 85% of the time. In the 1987 scenario, the value of the preferred stock fell and the Treasury futures rose. Since this strategy involved shorting the futures, it proved unsuccessful on both sides.    

Dynamic Hedge: Involves changing the amount of puts in a position over time, according to the market environment. This can protect against the downside risk associated with a long position.    

Static Hedge: Involves hedging out every dollar of a portfolio. In this way, it strives to eliminate risk.


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