Hedging as a risk management for stock investors
The stock market has been going through difficult times the last few weeks and the average investor is concerned. Nobody wants to loose money on their investment, but due to the nature of the stock market, money gained in a bull market is money lost in a bear market.
But there is a way to manage the risk involved in trading the markets. Hedging is the main function of the Futures market, were an individual can enter an opposite position to his natural position. A stock owner is like a producer, in that he’s naturally long the market, he needs to sell his asset to profit from them. For an individual who is naturally long the market, he needs to take a short position in the same or highly correlated market. For example a farmer growing corn, going short a Cbot Corn Futures contract would balance out his position. A stock investor would take a short position in a stock index that correlates to his portfolio. For a general stock investor, a short position in the S&P500 index Futures would make sense, as that would hedge him against the main economic draw-downs of the market. For investors in a S&P500 index fund, this would be even more appropriate.
But what’s the catch, there always is, isn’t it? Well there is a catch. When hedging a cash position in the Futures market, a owner of a stock portfolio would sell, or go short, the S&P500 index Futures. When going short, the position profits when the price declines and thus offsetting the loss on the natural long position. So when an investor looses on his stock portfolio, he profits on his short position. But on the other hand, if the market is not going down, but up, the S&P500 position is loosing money while the cash position is profiting. This means that the profit made on the cash position is offset by the loss in the Futures position. A Futures hedge means that the hedger is not loosing money, but he’s not making any either.
The solution to this would be to use Options on the Futures market. Options are preferable to Futures for the reason that when a natural long buys a put Option, he’s paying a premium for the Option. The cost of the premium is the only cost he incurs. So if the prices go down he’s limited his loss to the premium. But if the prices go up, he can always sell or exercised his option and thus profited from the difference between the profit of the Option and the premium.
Hedging a position in a similar or same markets is a valid way to limit losses in a losing position. Of course the best way to limit losses is to get out of a position, but if the investor believes the negative results of the market to be a short term phenomenon, the hedging is a way for him to limit his losses for a short duration of time.
