Risk being an inherent and precarious element of investing, hedging is basically an investment strategy employed to reduce risk by making a transaction in one market to offset a loss in another. Put more simply, hedging is taking equal and opposite positions in two negatively correlated (meaning if security A goes up, then security B goes down, and vice-versa) securities to lower risk of loss.

Theoretically, a perfect hedge would be one that eliminates all and any risk altogether from an investor’s portfolio, but that would mean there is no potential for upside either. In the real world, therefore, hedging is used by hedge funds preponderantly to reduce volatility and risk while trying to protect principal and deliver positive (absolute) returns under any and all market conditions.

Hedge funds, actually a misnomer as not all investment strategies involve hedging, use a wide variety of alternative strategies to invest. As opposed to mutual funds, hedge funds are exempt from many rules and regulations of the SEC (and also do not have disclosure requirements). This gives hedge funds the flexibility, and advantage, of being able to invest with a wider range of strategies including hedging strategies to protect downside risk.

Some of the hedging techniques, each involving an array of financial implements and each offering different degrees of risk and reward, employed by hedge funds are outlined below and can be utilized by sophisticated individual investors to protect their own portfolio.

SHORT SELLING

While short selling by itself is not a hedging strategy (it is often used, though, as a hedging strategy in the context of a long-only portfolio), it is important to understand it in order to appreciate how it works as one leg of a hedging strategy.

When short selling, an investor sells borrowed shares with the anticipation that the price of the share will decline and with the intent of returning the shares back to the borrower. This is also referred to as taking a short position, as opposed to a long position (i.e. simply buying the security) which is opened in the expectation that the price of a particular stock will rise in the future.

If in actuality the price of the borrowed shares does drop, then the investor profits from buying back the borrowed shares sold and returning them to the borrower at the original price. To further clarify the profit made from a short transaction, let us consider this simple example: Assume that 100 shares are sold short by an investor for $5 a piece and her account is credited for $500. Say the price per share drops, as anticipated by the investor, to $3 and she closes out the position by buying back the 10 borrowed shares for $300. The investor makes a profit of $200, the difference between the short sale, i.e. $500, and the closing of the position, i.e. $300.

This all might seem simple, however, an in-depth analysis has to be undertaken by an investor to arrive at the premise that the price of a particular share will in fact fall and not rise. If the price of the share does increase, the investor will end up with the short end of the stick (no pun intended) and lose money.

Technically, the furthest the price of a share can drop to is zero and hence the upside is limited to the amount of investment, but the downside is theoretically infinite for there is no limit to what the price of a share might rise to. For this very reason the fluctuation in the price of the shares in question is followed with painstaking diligence by the investor. (Not to get ahead of ourselves, a cautious investor can hedge his short-selling risk by purchasing a call option on the same shares.)

LONG/SHORT EQUITY

Hedge funds utilize this strategy which involves buying certain stocks long and selling others short. This strategy was pioneered by Alfred W. Jones who is credited with starting the first hedge fund, A.W. Jones & Co., in 1949. Mr. Jones formulated the idea of hedging stocks by going both long and short with the aim to lessen the effects of market risk by hedging long equity positions with short positions.

To further clarify how market risk is hedged in this strategy, say that an investor might short sell a stock while buying a different one in the same industry. Now if the industry declines overall, then the short position would compensate for the loss acquired in the long position and in the case that the industry stocks rise the reverse would be true.

In either case, however, an astute balancing act has to be performed by the investor in estimating and hedging the risk to market exposure. Market exposure is determined by subtracting short positions from long positions, and the higher the difference (referred to as being ‘net long’), the higher the market risk.

ARBITRAGE

Arbitrage is the practice of simultaneously buying and selling two different, but highly correlated, stocks in the same market to profit from the unjustified disparity in their prices. Conversely, arbitration can be achieved by buying and selling the same stock in different markets and taking advantage of pricing inefficiencies (these opportunities are less and less common in today’s world of electronic trading). Ideally, an arbitrage transaction involves very little (if any) cash outflow and hence has the possibility of a very low-risk profit with very low cost to boot.

Arbitrage, sometimes referred to as ‘risk arbitrage’ or ‘merger arbitrage’, can be applied to special situations where a business is being acquired by, or merging with, another business. When a publicly traded business is being acquired, the acquiring business makes a tender offer – to the shareholders of the business being procured – which is usually higher than the market price. An investor may profit from this situation by buying the shares (at a lower price than the tender offer) of the company being acquired immediately after the tender offer has been announced, and then turning around to sell the shares back to the acquiring company at the tender price.

Practically speaking, the risk involved in jumping into the fray of special situations relies upon two main factors: Will the merger or acquisition go through? And, if it does go through, what will be the amount of the final tender offer? These two risks can be taken head-on and be classified as pre-emptive and post-tender respectively. The former being more risky as it is speculative and visceral because the investor purchases shares based upon the conjecture that the M&A deal will materialize. And assuming that the merger does go through, the final tender price may come in higher or lower than the original tender. (Again, not to get ahead of ourselves, these risks can be mitigated by being long convertible bonds and short the underlying equity.)

OPTIONS

An option, akin to a future, is essentially a derivative. A derivative is anything whose value is based upon some other asset, i.e. it derives its value from something else. Specifically, derivatives are securities whose prices are based on the prices of an underlying asset, namely equities, bonds, real estate, commodities, etc. Derivatives are prominently used to hedge and reduce risk of an investment in the underlying security. Besides futures, the most common derivatives used for hedging are options which are used to develop a hedging strategy where a loss in an investment can be offset by a gain in the option contract.

There are myriad ways of using options to hedge a portfolio. One common use of options is to curtail the possibility of losses in a specific security. An investment can be protected by buying a put option on it — this gives the investor the right to sell the investment at a specified price (known as the strike price) for a specified time period. Now, if the stock price falls below the strike price, then the losses can be compensated for by gains in the put option (meaning one does not have to exercise the put option). In the same fashion, a call option can be used to hedge losses arising from a short position in a stock, as the call option gives the investor the right to buy the stock at a specified price.