What's Your Hedge Ratio?

A hedge is an investment that is made with the intention of reducing the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting or opposite position in a related security.

How Does Hedging Work?

A perfect hedge is one that eliminates all risk in a position or portfolio. In other words, the hedge is 100% inversely correlated to the vulnerable asset. This is more an ideal than a reality on the ground, and even the hypothetical perfect hedge is not without cost.

Basis risk refers to the risk that an asset and a hedge will not move in opposite directions as expected; "basis" refers to the discrepancy.

How Long-Short Equity Works

Long-short equity works by exploiting profit opportunities in both potential upside and downside expected price moves. This strategy identifies and takes long positions in stocks identified as being relatively underpriced while selling short stocks that are deemed

to be overpriced.

Long-Short Equity Example: The Pair Trade

A popular variation of the long-short model is that of the “pair trade," which involves offsetting a long position on a stock with a short position on another stock in the same sector. For example, an investor/trader in the technology space may take a long position in

Microsoft and offset that with a short position in Intel. If the investor/trader buys 1,000 shares of Microsoft at $33 each, and Intel is trading at $22, the short leg of this paired trade would involve purchasing 1,500 Intel shares so that the dollar amounts of the long and short positions are equal. The ideal situation for this long-short strategy would be for Microsoft to appreciate and for Intel to decline. If Microsoft rises to $35 and Intel falls to $21, the overall profit on this strategy would be $3,500. Even if Intel advances to $23—since the same factors typically drive stocks up or down in a specific sector—the strategy would still be profitable at $500, although much less so.

Conclusion

With Sector Divergence stocks trend to move up or down within The Market cycle, long-short strategies frequently to use different sectors for the long and short hedge. For example, if travel and leisure industry is in COVID Pandemic alert, a hedge strategy may short interest-sensitive sectors such as industrials, and go long on technology sectors and healthcare.

Take control of your financial impact....Embrace the Uncertainty of Probability!