The Art of Hedging

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Homogenous Hedging

Hedging inadvertently became a hot button issue recently amidst the Game Stop saga that was played out between Wall Street and Reddit trading groups. However, hedging is a common trading strategy widely used by institutional investors and retrial traders alike to reduce the underlying risks from sudden market changes.

In this first segment of a broader topic covering the art of hedging, we set out to describe what we refer to as homogenous hedging. It could be done using assets from the same underlying category - shares of companies within the same industry; commodities of the same kind, such as metals; FX pairs with the same baseline currency; and others.

For instance, consider two mining companies – company AA and company BB – both of which produce copper and are two of the industry's most influential members. An investor might decide to purchase a given amount of shares of AA as his primary investment. However, he fears that an industry-related issue might impede AA's operations and, therefore, send its share price tumbling down. Assume that he purchases X amount of AA shares at $60 per share.

As a precautionary measure, he can also purchase a put option on BB's shares, as this company, too, would be affected negatively if anything detrimental were to happen to the copper industry. The put option entitles the investor with the right (but not obligation) to sell the futures contract on the underlying asset (BB's shares) upon the option's maturity at a predetermined price, called the strike price. For example, if the price of BB’s shares were $50 at the time when the investor purchased his put option, which has a strike price of $48, he would exercise his option if the price falls below $48. Assume that the price eventually falls to $45 upon the option's maturity date (exercise date). The investor would then choose to exercise his put option at $48, and his profit would be the three dollars' difference. The cost of obtaining an option is called the premium. The premium will turn into a loss if the price of the underlying does not depreciate over time.

Therefore, if something happens to the industry, and the price of copper goes down, both AA and BB's share prices would be negatively affected. The investor's primary position would suffer as the share price of AA tumbles, and he would incur a loss from it. BB's share price would be affected negatively, too, so he would decide to exercise his put option and sell the underlying, which means that the investor would generate a profit from his secondary position. Thus, the principal goal of a well-structured homogenous hedge is for the gains of one position to offset the incurred losses from the other position/s. The profit/loss relationship between the two positions looks like this:

After the mining industry takes a hit, and the price of copper decreases, the shares of AA and BB both depreciate from their original levels - $60 and $50 respectively. Presumably, the stop-loss order of the primary investment is going to be triggered somewhere close to the entry price level, so that more significant losses can be averted. The red chequered area represents those potential losses, which are virtually unlimited as the price continues to decrease.

The secondary position, which is the actual hedge, starts at a loss at the time the put option is purchased, owing to the payable premium. Moreover, the potential loss from such a position can never exceed the amount of the premium. Regardless of how much the underlying's price appreciates before the maturity date of the option. Once the price of the underlying depreciates below the strike price, which is set at $48, the put option would become profitable, and it would be exercised before its maturity. The green chequered area represents this margin for profit.

Supposing the investor manages to sell his shares of AA when the price depreciates to $59, he would have incurred a $1 loss on his X amount of AA shares. Furthermore, if BB's share price was to fall to $45 eventually, that means that he would exercise his put option with a strike price of $48. Consequently, he would have garnered $3 from his put option. Depending on his hedge's contract size, he would be able to offset the incurred losses from his primary position at least partially.

Overall, an ideal hedge is one that would yield net profits regardless of where the market goes eventually. If it heads in the initially anticipated direction, then the generated profits from the primary position will be decreased by the incurred losses from the hedging position. If those profits are less than the payable premium value, then the position would generate net losses. That is why the primary position's margin cannot be equal to the margin set aside for the hedge.

Respectively, if the market goes down, then the collected profits from the hedging position will be used to offset the incurred losses from the primary position. Similarly, if those profits are lesser than the incurred losses from the primary position, the overall result would be a net loss. In that respect, homogeneous hedging involves purchasing two or more similar assets with different contract types (e.g. equity ownership for the primary position and options trading used for the hedge).

There needs to be an established and observable correlation in the assets' price action since they belong to the same asset class. The correlation can be determined by examining how the different assets' prices react to the same market conditions. In the example above, the two companies are part of the same industry, which entails such a correlation.