Introduction to Hedging
Hedge Your Bets
Many of us have tried our luck at the Blackjack table. Of course, most of us aren’t professional card counters. We’re probably all at least partially vulnerable to the intoxicating mix of chemicals in our brain that is released when we win at gambling.
We’ve all probably experienced that moment when we get a face card and get excited at impending victory, only to see that awkward smile go across the dealers’ faces as they flip an ace that was lying in hiding under their exposed face card. It is not a good feeling, and if you’ve had severe investing losses in the past, you probably recognize the feelings and thought processes involved.
There’s a product called insurance that will protect your bet in this worst-case scenario. It is a side bet that pays out 2/1. It offers the gambler a way to insure his bet even the dealer draws a blackjack and results in breaking even. If you’re doing a Martingale Strategy, it can really save the day. If the dealer’s face card is an Ace, players will often buy insurance against the close to 1/3 probability that the dealer will draw a ten and win.
The logic underpinning Blackjack insurance, insuring yourself against loss in bad scenarios, is the same logic that hedging has grown out of. Some laws require you to ensure what is most Americans’ main asset, their homes. If you insure your home, you should probably insure your portfolio to at least some degree. You have more options to achieve this objective than have ever been available to investors. Is it more important to eat well or sleep well, though?
This will depend on each investor’s individual objectives and risk tolerances. Hedging risk can get expensive, and therefore one of the most important things to consider when embarking on the mental journey of risk management can be how to protect yourself from risks cost-effectively. Maybe you can stomach small market movements; perhaps all you want to do is hedge against calamitous events. We’ll help you wrap your head around some strategies.
Traders love to use hedging and leverage to amplify returns and protect themselves against risk. While many newer investors have discovered how you can amplify returns using leverage when things are going your way, decidedly less have been practicing cost-effective, risk-defining strategies that can help you avoid a costly disaster.
Many investors have a firm understanding of how long the call or put option can be used. However, combining different contracts can give you the power to control risk in a more precise fashion than you may have imagined possible.
Combining contracts to color within the lines you define for yourself is a powerful ability that was out of range for investors for much of the twentieth century. The derivatives market has grown to exceed $600 trillion in notional exposure, so we’d say they’ve gained some popularity. Despite reputational damage from the Global Financial Crisis, most of this is used to define and control risk, not augment it to problematic levels.
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