Foreword
While hedging is mentioned in finance a lot, it is, surprisingly, not very well defined. Despite its frequent use in finance literature, it seems that most people have a rather hazy mental model of what hedging is, or how it works.
As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.
If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.
What is hedging
To try and make the discussion more concrete, I’m going to provide my own mental model of what hedging is. To put it simply, a hedge is simply an auxiliary position that reduces the risk of your main position, where “risk” is defined as the variability (i.e. variance) of the combined positions performance.
Types of hedging
In my framework, there are 2 main types of hedging:
Mechanical hedges
Mechanical hedges are positions which “mechanically” go down (or up) in value as your main position goes up (or down) in value. For example, buying a put to hedge your stock exposure is a mechanical hedge — the value of the put mechanically goes up or down as the value of the stock goes down or up.
Similarly, TIPS are a form of mechanical inflation hedge — as inflation (as measured by the CPI) goes up or down, the value of the bond mechanically goes up or down.
The key thing to note, is that the value of the hedge moves inversely to the main position, regardless of market conditions. This generally happens because there is arbitrage between the main position and the hedge, such that any spreads will be swiftly closed by market makers, and/or there is an authority (such as a regulator, a government, an exchange, etc.) that enforces that the hedge moves inversely with the main position.
Statistical hedges
Statistical hedges are positions which are known to generally go down (or up) in value as the main position goes up (or down) in value, though there is no guarantee for them to always do so.
For example, in the classic 60/40 portfolio, the 40% of the portfolio in bonds can be thought of as a hedge for the 60% of the portfolio in stocks. Over the short/medium term, the value of bonds tend to move inversely with the value of stocks.
Other types of statistical hedges generally involve what is colloquially known as “pair trades”. For example, the value of the Australian dollar tends to move with high correlation to the value of the Canadian dollar, as both countries are commodities exporters with fairly similar exports, so changes in commodity prices tend to affect both. Thus, AUDUSD (Australian dollar valued in US dollars) and USDCAD (US dollar valued in Canadian dollars) tend to move inversely with each other — it used to be profitable to trade these 2 in a pair trade that bets that any gaps in performance will eventually close.
Observations
- Assuming you do not rebalance, your total position (main position + hedge position) cannot perform better or worse than your main position. The performance of your total position, absent rebalancing, is always of a smaller amplitude of your main position.
- If you find that your total position actually went up in value despite your main position going down in value (i.e. your hedge position went up in value more than your main position went down), then you’ve made a mistake — your main position is actually the hedge and vice versa.
- If you rebalance smartly, then it is possible for your total position to perform better than your main position, and with lesser risk (i.e. smaller variance).
- This is a result of the Modern Portfolio Theory. In simple terms, when your main position goes down in value (and your hedge goes up in value), you’ll sell some of the hedge position to buy the main position, and vice versa. Assuming the main position generally increases in value over time (i.e. your main thesis is correct), then this essentially forces you to buy low and sell high, and over time, should outperform the main position, but with smaller variance.
- If the value of the hedge consistently or generally goes down when the value of the main position goes down, then you’ve made a mistake — the “hedge” is simply not a hedge for the main position.
- If the value of the hedge moves essentially randomly with regards to the value of the main position, then it can still be used as a hedge, but only if you rebalance diligently and size the positions properly.
- This is a result of the Modern Portfolio Theory.
My personal hedging
If you follow my positions on StockClubs (Disclaimer: I am an investor in the app, and only show 1 [of 10+] brokerage accounts in that app), then you’ll see that I very often sell calls against my stock positions. In a hand-wavy kind of way, these can be considered as hedges as well — the short call goes up in value (less negative) if the stock goes down in value.
One way of thinking about this, is that I’m giving up some upside for the stock position, to reduce some downside (if the stock goes down in value, the premium from selling the calls “absorbs” some of that loss).
Janky Thoughts 