The Art of Hedging

05/16/2013 7:00 am EST


It's possible to mitigate your risk and protect your portfolio by learning how to use simple hedge strategies, writes Dr. Kent Moors of Money Morning.

The art of the traditional hedge involves employing a very simple concept. By taking at least two opposite positions, an investor couches a portfolio against the full impact of major pricing volatility. One should go up, the other down, regardless of what the market actually does.

Such an insurance policy always has a slight preference in one direction or the other. Otherwise, a perfectly structured hedge will result in a 0% return.

Futures contracts are a case in point. The objective is to "insure" one position by taking another in the opposite direction. There, one could take an option in an attempt to offset volatility in a contract already held. The option gives an investor the right—but not the obligation—to a certain asset at a specific price and time. A futures contract requires that such a purchase be made.

If the initial contract turns out to be correct, the option is allowed to expire, and the investor sacrifices only the premiums paid for the option. The downside is the amount one has to pony up for a futures contract. One in crude, for example, requires the purchase of 1,000 barrels of oil.

However, if not investing in futures contracts on commodities (or any financial asset for that matter) or stock options, hedging strategies are designed as an offset to simple changes in stock prices.

This is accomplished by acquiring stocks that tend to profit when underlying fundamentals go in different directions. A direct simple play here on the underlying oil would be buying into exchange traded funds that improve when oil goes up—for example, the S&P GSCI Crude Oil TR Index ETN (OIL)-and offsetting that by purchasing one that improves when the oil price moves south. The most used here is ProShares UltraShort DJ-UBS Crude Oil (SCO).

But hedging can also be used with all manner of straight stocks. One particularly straightforward approach is to parallel companies sensitive to natural gas price fluctuations. In this example, you want to benefit if the price goes up or down.

Many investors will think this is a recipe to short stocks. The short is designed to make money if a stock is declining in value. The problem with shorts for the normal investor—and the reason I do not recommend them—is the risk. If you are wrong and the stock moves up, there is theoretically no limit to how much you can lose.

An ETF such as SCO mentioned above is a short fund. But you are buying and selling it as a normal stock. That insulates you from the dangers of a direct short, although an ETF also costs you some loss of proceeds in fees.

But back to the natural gas example. A direct hedge using stock would involve holding both a gas producer and a utility employing gas as a fuel source for the generation of electricity. If the price of the gas goes up, the producer wins, but the utility would decline, since it would experience a rise in generating costs. A decline in gas prices would tend to have the opposite effect.

You can readily see the same sort of dynamic in operation with respect to pipeline and other midstream services, refineries, and the relationship between equipment manufacturers and oilfield service providers.

A period of narrow price variations in the underlying raw material—in our case oil or gas—is a good opportunity to establish such a traditional hedge. That is because it will not subject you too much downside risk, regardless of which way the market moves. And that allows for some experimentation.

Read more from Money Morning here...

Related Articles:

Forex Trading: Is There an Advantage to Hedging?

Hedging the Most Actively Traded ETFs

Simple Hedging Strategies for Anyone

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