Any trader who has been in a stock, FX or commodity trade knows how disheartening it becomes if one was of the opinion that the trading instrument would go in a certain direction and it turns around right after the trade is made and heads in the opposite direction.
A stop loss often simply does not help much, especially if it is virtually certain the price will eventually turn around and head in the ‘right’ direction. What one needs is a hedge to remain in the trade no matter in which direction it goes.
A hedge is simply a ‘counter-transaction’ that will protect a trade against potential losses by way of making a profit if the price of the underlying asset moves against the trader (or investor).
With the advent of options, a whole new world has opened up to traders, enabling them to more effectively hedge stock, FX or futures positions than at any time in the past.
A simple example: The protective put
The protective put is a very basic example of a hedge. A trader who is in a long position on a stock would simply buy one ATM put contract for every 100 shares he or she owns in the underlying stock.
Fig. 9.03 (a) below is an example of the risk profile of the new trade.
From the above chart it is immediately clear that:
If the price of the shares goes up, the trader will still benefit from the full price increase, less the cost of the put options.
If the price goes down, the trader does not stand to lose a virtually unlimited amount of money; instead his or her losses will be limited to the cost of the long put options.
Hedging against price increases
A manufacturer who stands to lose from a price increase in e.g. the price of oil, could benefit from hedging against this eventuality by buying call options on oil. Fig. 9.03(b) shows this person’s new risk profile after buying call options to hedge against price increases.
From this chart it becomes clear that:
If the price of oil increases, the maximum loss remains equal to the purchase price of the call options and
If the price of oil declines, the manufacturer would still benefit from the full drop in the price of the commodity, less the cost of the call options.
When to hedge and when not to
Some long-term traders (investors) refrain from hedging their portfolios because they have the mistaken belief that the stock market will always go up in the long term. The turmoil through which markets went after the 2007 financial crisis in the US which subsequently swept through virtually the whole world proved this to be not true.
The only time a hedge is not worthwhile is when the potential price decline of the underlying asset is less than the cost of the hedge. Buying ATM put options costs money and it makes no sense to spend $20 000 on a hedge of the expected downside risk is only $10 000. Since accurately assessing downside risks is very difficult indeed, hedging a portfolio makes sense in virtually every possible scenario one can think of.
Hedging is what allows professional traders to remain in business for years, while many retail traders are forced out of the market once they have lost a significant percentage of their trading accounts. It is also a common practice in the world of international trade where millions can be lost or gained by protecting oneself against fluctuations in the prices of currencies and/or commodities.