Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Perfect Hedge

What it is:

In finance, a perfect hedge is an investing strategy intended to protect an investment or portfolio against all losses. It usually involves securities that move in the opposite direction than the asset being protected.
 

How it works (Example):

Let's assume part of your investment portfolio includes 100 shares of Company XYZ, which manufactures autos. Because the auto industry is cyclical (meaning Company XYZ usually sells more cars and is more profitable during economic booms and sells fewer cars and is less profitable during economic slumps), Company XYZ shares will probably be worth less if the economy starts to deteriorate. How do you protect your investment?

One way is to buy defensive stocks. These stocks might be from the food, utility or other industries that sell products consumers consider basic necessities. During economic slumps, these stocks tend to gain or at least hold their value. Thus, these stocks may gain when your XYZ shares lose. If the portion of your portfolio invested in these stocks gains a dollar in value every time the portion of your portfolio invested in auto stocks loses a dollar in value, you have a perfect hedge. When one goes down, the other one rises to make up the difference.

Another way to hedge is through options. For example, you could purchase a put option contract on your auto shares (this would essentially allow you to "lock in" a particular sale price on XYZ, so even if the stock crashed, you wouldn't suffer much). You could also sell a futures contract, promising to sell your stock at a set price at a certain point in the future.

However, if you hold a large, diversified portfolio of stocks, then it is probably not cost-effective to try to get a perfect hedge on each and every position. Therefore, you might want to hedge your entire portfolio by using index options. Index options are options not on an individual stock, but on an entire index, such as the Nasdaq 100, the Dow Jones Industrial Average, and the S&P 500. (You’ll first need to figure out which indexes are most similar to your portfolio.).

The term delta describes how much your  hedging instrument moves for each $1 change in the price of whatever it is you’re trying to hedge. In other words, delta is a mathematical measure of the "strength" of a hedge.
 

Why it Matters:

Finding the perfect hedge is like buying insurance. It is protection against unforeseen events, but hopefully you never have to use it. And hedging, like insurance, usually doesn’t protect against every unforeseen circumstance or provide as much payment for losses as one might expect.

Ideally, an investor wants a perfect hedge, because it means his risk has been reduced to nothing except the cost of the hedge. However, should a stock or portfolio take an unforeseen turn, an imperfect hedge is probably better than no hedge at all.

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