Hedging?

[ChristiansburgTrader]

Dear Forum,
How is it possible to protect losses and guarantee a profit by taking an opposite position? Seems like you would loose on commissions alone!
Thank you!
Mike

[Airelon]

Many times, the position is offset by a little bit. In other words, you don't buy and sell at the same price. A person my buy X at $10.00. Then they sell X at $9.50. The spread or difference, is what they are looking to profit from many times.

[jsssm]

First off, there is no way to guarantee profit. The two most common hedges are

(1) selling a call option - if you own AAPL and it is trading at 100, you sell the 110 call option for $5. you cap your profits at $15 but also protect up to $5 in losses.
(2) short an index or weaker stock - if you own AAPL, you can short QQQQ hoping AAPL outperforms the index, or short GOOG because you think AAPL will outperform GOOG

[Matt Moss]

Hedging is designed as a way to eliminate or isolate specific risks. Guaranteed profit is called "arbitrage," and is a seperate concept from hedging.

For example, lets say you were expecting a friend to pay you $1000 in 6 month, but your friend was going to pay you in Euros. You are then taking the risk that the exchange rate will change in the next 6 months. Something you could do would be to sell a futures contract and lock in the current exchange rate. This "hedges" or eliminates the risk of the USD/EURO exchange rate changing in the next 6 months.

Note: this eliminates your opportunity for any positive change in the XR as well as a negative change. So it doesn't guarantee a profit, but simply eliminates the risk altogether.

A lot of times when you purchase a security, it will have many different risks embedded into it. Take an option, for example. An option's price will change given a change in the underlying stock price, a change in the expected volatility, a change in interest rates, or a change in expected dividends. The idea of hedging is, you can eliminate some of these risks from impacting your profit or loss. A "delta hedge" is a way of eliminating a change in the underlying stock price from impacting the value of your overall position, for example.

Hedging is all about eliminating specific risks. If you are looking into ways to earn a return greater than the risk free rate while taking no risk, then arbitrage is what you'll want to look into. However, true arbitrage strategies involve extremely complicated math and super-fast computers; ie, they are not for the individual investor.

[dgiles63]

If you look at a typical stock chart, the price doesn't go straight up. You hope that the stock price exhibits higher highs and higher lows over time. If you buy a stock that is in an uptrend as I just described it, you don't know where the tops or bottoms will be, but you can draw some lines that suggest that it might be 5 or 10 percent higher in the next two months. If you sell a covered call at, a strike price of say, 5% higher than the current price, you may bring in another 2 or 3% of the current stock price. The call will be out a couple of months. If your estimates are right, you would make the 5% stock price growth plus the 2 or 3 percent that you collected from the covered call. This represents a hedge because you make the price of the covered call whether the stock price goes up or not. It also means that the stock price can come down as much as the cost of the covered call, before you start to lose money on the over-all trade. The risk, of course, is that the stock price will break away from your estimate, and would have returned more that the strike price plus the covered call premium.

[dgiles63]

The other way to hedge is to buy a short term put. If you hold a long term stock position, you want that stock to gain in value over time, however, we all know that stock price fluctuates. After those times where the stock price has gained some significant price increases, especially if you see that the price has pierced the upper Bollinger Bands, then it can be assumed that gravity will finally have some effect on the stock price. If you want to continue to hold that stock in your portfolio, you may want to buy a short term put at the current stock price. As the stock price pulls back, the put earns money and "hedges" the profits that you have made in the last run up. If the stock does not recover over the term of the put, you can exercise your option and sell the stock for the strike price, insuring that you get that best price that the stock reached during it's run up.