What is Hedging?

expand iconexpand iconexpand icon16 FEB 2022
Reducing risk of losses with offsetting investments.
TABLE OF CONTENTS

How hedging works

Other Ways of Hedging

Factor Hedging in Portfolios

Example

99rises Hedging Philosophy

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Hedging is defined as either buying or selling an investment instrument or security to reduce the risk of losses from another portfolio or investment. The hedge characteristics are generally opposite in nature to the investment that is being protected from losses. For example, shorting or buying put options is a common strategy to offset losses in core portfolios or equity investments.

How hedging works

As alluded to above, using short-selling or purchasing derivatives or futures contracts are methods used for hedging. One should think about these offsetting positions as insurance against your investments. As is the case with insurance, these instruments are not free and therefore, akin to insurance premiums, there is a cost in purchasing a hedge. In case of derivatives, the cost of the insurance of buying puts, for example, is called the option premium which the put buyer has to spend. The option premium is calculated using the Black-Scholes model.

Black-Scholes is a pricing model used to determine the fair price or theoretical value for a call or a put option based on six variables such as volatility, type of option, underlying stock price, time, strike price, and risk-free rate.

On the other hand, shorting stock or indices involves borrowing that instrument with a promise-to-deliver the security at a future time. The borrowing comes at a price called the cost of borrow. The harder the security is to borrow, the higher the cost of borrow. This ranges from a few hundred basis points to over ten percent in hard to borrow securities.

Other Ways of Hedging

Sector rotation and re-allocation serve as strong methods for hedging against losses. Specifically, investing in uncorrelated sectors reduces the probability of large losses because such sectors move in the opposite direction to the markets. For example, buying gold, treasuries and bond-like sectors like utilities and consumer staples in times of market duress can alleviate a lot of pain by providing protection against drawdowns.

Next, active re-allocation and portfolio rebalancing helps sizing each portfolio position accurately and thus minimizes risks associated with having concentrated portfolios.

Factor Hedging in Portfolios

In addition to the above methods, 99rises uses a multi-factor model to construct blocks which builds on top of the Capital Asset Pricing Model (CAPM). We have over ten factors (for e.g. volatility, leverage, size, yield, growth, value etc.) we track, and if either of these factors are greater or less than our block rules, we hedge by adjusting the sizing of the individual positions in the block or adding or shorting sector or index ETFs that bring us back in line. This level of rigor is critical in managing risk for clients in this day and age when algorithms and hedge funds account for 90% of the daily average trading volumes. As a case in point, one such big fund having issues can have a massive impact on individual positions and our blocks stand a chance to lose a lot, very quickly.

Example

Let’s say you buy $1,000 worth of Chevron (CVX) because you think oil prices will go up as a result of weakening supply and strengthening demand over the next year. After putting the trade on, you realize that almost everybody else is long CVX and that demand may not materialize as expected as a result of a potential trade war. You want to sleep well at night, and you therefore come up with the following hedges: (i) Short $500 worth of Exploration and Production Index (XOP) which has a 0.9 correlation to oil prices. This is a pure offsetting hedge. (ii) Buy $200 worth of Exxon (XOM) put options expiring in 9 months because you think XOM is a weaker company than CVX and has the same correlation to oil price fluctuations. This is the best hedge, as it not only protects you one to one on your CVX investment of oil prices go down, but also gives you the extra edge in case XOM goes down because of operational faux pas irrespective of oil prices going up or down. (iii) Short $150 worth oil futures expiring in 6 months which has a 4.0 times leverage factor, so every unit move in oil cause a four times move in the futures. This is risky as you will lose money if oil prices go up, but your investment in CVX is protected if oil prices go down. This is the weakest hedge of them all.

99rises Hedging Philosophy

We aspire to make you a return on your capital irrespective of market gyrations up or down. 99rises invests in portfolios designed to withstand bull and bear markets. With sophisticated portfolio construction, in rising markets, in theory, your longs should go up more than your shorts, while in falling markets, the shorts should fall more than the longs, thus generating positive returns in both scenarios or at the very least protect your portfolio from big losses.

Our shorts serve as a natural hedge for your portfolio. In addition, if we deem the need to add incremental insurance against losses, we use inverse ETFs to prevent downside and protect your capital.

Stay safe, stay nimble, stay humble!

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