Avoid Being Sheared! Use Hedging to Reduce Downside Risk

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To the uninitiated, hedging may seem like a complex strategy reserved for sophisticated traders, but it is actually a very simple way for any portfolio manager to control their risk.

Investopedia says, “although it sounds like your neighbor's hobby who's obsessed with his topiary garden full of tall bushes . . . hedging is a practice every investor should know about. “

Hedging offers an excellent way to avoid being eaten by the sharks or as the title states, being sheared like a lamb. Unless you have a good strategy to protect yourself against downside risk, you will be lunch for sharks or led to the slaughter like a lamb.

How Hedging Works

Recognizing first and foremost, that the stock market is the world’s largest gambling casino and the cards are stacked against you, go into all investing and trading with your eyes wide open.

Always remember  that no matter how much you research and study, the moment you go to “place your bet” the wheels are in motion to take your money away from you and you want to do everything you can to minimize your losses and hopefully come away with gains when you make the right bets at the right time.

Here’s how it works. In their beginners guide to hedging, Investopedia says the best way to think of hedging is to compare it to insurance. More simply, when you buy a stock, you “hedge” by taking out an insurance policy on your purchase just like you insure your care or your home.

If the stock goes against you, the insurance policy you purchased for a fraction of the cost of the stock itself, protects you if the stock goes south.

The Mechanics of Hedging

Hedging in the stock market is not quite as simple as contacting your insurance agent and buying a policy but it can be nearly that simple once you get the hang of it. When you hedge, you are taking two positions at the very same time with “negative correlations.” On the buy side of your position, you are betting the stock will go up and on the put option side, you are protecting yourself, or hedging, if it goes down.

To cover a short position where you are betting the stock will go down, you simply reverse the process.  You “sell” a stock you don’t own and then buy a “call option” for the negatively correlated position.

Risks and Rewards of Hedging

Since nothing in life is truly free, it’s important to point out that hedging itself has risks and rewards. One of the most important risks is that when working with options, they have expiration dates and when they expire your “position” become worthless and you lose all the money you used to purchase the option in the first place.

You also must understand that hedging reduces your overall potential profit because it costs you something to take a negatively correlating position. That cost comes directly off your bottom line. Remember that hedging in and of itself will not make you money, but is a strategy to reduce your risk.

Who Uses Hedging and What is Straddling?

As stated previously, most traders or investors who employ hedging strategies use put and call options to take their negatively correlating positions. They develop trading strategies and systems to offset their potential losses on one side of a stock to offset the other.

More sophisticated traders also use a more intricate strategy called straddling.  In straddling, you a position in both a call and put with the same strike price and expiration date. In theory, you are covered whether the stock goes up or down but in order to make a profit, the stock must move significantly in either direction.  

Summary

Hedging gives even everyday investors and traders an excellent way to manager risk. By taking a “negatively correlating” position in the form of put and call options, you can reduce your overall risk of loss if a stock moves in the opposite direction you anticipated.

There is a cost to hedging whereby it can reduce your overall profit, but many experienced investors feel the reduced profit is worth the risk.  

Using hedging strategies is a great way to avoid being sheared in the stock market because you cover yourself in up, down and sideways markets. You are even covered if the market suddenly crashes and option activity tends to increase when people begin to feel uneasy about markets topping out.

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