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Hedging – Introduction Outline

What is Hedging 

  • Hedging involves trying to limit risks in financial assets
  • Popular hedging techniques look to offset positions in some way
  • Derivatives can be used to hedge
  • Other forms of hedging involve diversification

Importance of Hedging

  • Limiting risk and not necessarily return
  • Minimizing unwanted exposure
  • Creation of positions matching thesis

How to Hedge Stock Portfolios

  • Diversification
    • Eliminate unsystematic risk
    • Capitalize on growth from various industries
  • Mix short and long positions
    • Minimizes systematic risk
    • Capitalizes on relative performance
  • Derivatives
    • Sell calls to limit upside but collect premium
    • Purchase puts to limit downside risk
    • Sell puts to lower your cost basis when appropriate

Hedging a stock portfolio with derivatives

  • Covered Calls
  • Long Puts
  • Protective Puts & Married Puts

How to Hedge Option Portfolios

  • Understanding the Greeks 
  • Refrain from being overexposed 
  • Consider delta neutrality 
  • Mix various trading strategies for uncorrelated positions

Option Hedging Portfolios – Greeks

  • Delta: sensitivity of an option’s price to change in the value of the underlying
  • Theta: Rate of time decay of an option
  • Gamma: rate of change of delta relative to the change of the price of the underlying
  • Vega: option’s sensitivity to volatility 

Option Hedging Portfolios – Delta-Neutral

  • Delta Neutral also known as market-neutral
  • Balancing bullish and bearish positions
  • Beta weighting to and index or SPY
  • Minimize leverage and drawdowns

Summary

  • It is critical to hedge in all markets
  • Understand your options when it comes to hedging
  • Look where your risks lie for a given portfolio