Hedging involves trying to limit risks in financial assets. It is an important part of any trading or investing across stock and option portfolios, as well as commodities, fixed income products, and even real estate. Popular hedging techniques look to offset positions in some way. There is often a give and take with a hedge so it is important to know what risks one hopes to limit with a hedge. Derivatives can be used to hedge and make for great tools. Derivatives are often used to speculate and hedge given their inherent leverage and variety. Other forms of hedging involve diversification. Diversification is important for all types of investing as it limits risk and allows for a better chance of capital preservation and appreciation even with positions going against you.
Limiting risk is not necessarily limiting return. While economics and many in the news view risk and volatility as synonymous and risk and return as perfectly correlated this is not the case. Diversification can limit unnecessary risk without inherently limiting return. Hedges are critical to minimizing unwanted exposure. This could be an unwanted long exposure to the market, or when trading options you may have exposure to volatility you find unfavorable. It is also important to match the creation of hedges to positions with the same thesis. When trading and investing it is important to have a strategy and thesis for a specific position and the hedge should fit within this thesis.
Diversification is critical for stock portfolios as it allows you to eliminate unsystematic risk. While any long exposure you have will have systematic / market risk, you can eliminate the individual company risk through diversification. This also has the benefit of capitalizing on growth from various industries as different industries and companies outperform in different market conditions.
Like the original hedge funds, one can mix short and long positions to eliminate the market risk. This strategy would imply a large move up or down in the market would not impact the portfolio, but rather capitalize on relative performance to generate what is known as alpha. One can also short some stocks but still be net long to limit exposure to the market while still remaining net bullish.
Derivatives can be great tools for hedging stock portfolios as well given their leverage and options. You can sell calls to limit upside but collect premium or for a stronger and more bearish view on long stock you may hold, purchase puts to limit downside risk.
To hedge option portfolios it is critical to understand the Greeks as they can represent many of the risks that can be minimized.
It is also critical to refrain from being overexposed. One can look at their portfolio risks and greeks to see if they are comfortable with the exposure they have and ideally minimize volatility and max drawdowns in the portfolio to stimulate portfolio longevity and capital appreciation. Consider delta neutrality and mix various trading strategies and/or asset classes for uncorrelated positions.
Delta Neutral is also known as market-neutral. This can be accomplished by balancing bullish and bearish positions. To do this one can beta weight their portfolio to an index or SPY and then compare different underlying to understand the theoretical movement of their portfolio given the move of the market all things being equal. Lastly, minimizing leverage and drawdowns is key to an options portfolio as if left to its own accord, leverage can get out of hand and large swings would then be expected. Minimizing the volatility and swings in a portfolio will ensure a sequence of lost positions (going to happen given the probability of a single loss) will not result in a substantial drawdown that is far harder to recover from.
It is critical to hedge any type of portfolio and match the hedge for the exposure you hope to achieve and the risk you are willing to take. Ensuring you are not over-leveraged and properly diversified will increase the probability of success and limit unnecessary volatility and risk in a portfolio.