What is a Hedge?

By: ShortMeTina

What is a hedge or what does it mean; to hedge?  If you're a long-time follower or supporter of Short Me Tina, you are aware that I view the Stock Market as uncertain.  There are no guarantees when you place a trade.  That is, you have the potential to make a lot or lose a lot of money in the stock market.  When you're a market participant and engaged in the stock market, understand that your risk is always on.  There's just no going around it.   Or is there?

Unlike your typical bank, there is no FDIC rule that states you're secured for every $250k you have invested in the market.  Meaning, if your bank goes belly up, everything up to 250k is secure and/or insured.  In the strictest sense, there is no insurance for the stocks you own.  If the company goes belly up and that company’s stock crashes as a result, there’s potential to lose all your money.  That is, there is no FDIC equivalent to secure the amount you have invested; not even a partial amount. 
 
There are, however, processes or methodologies that you can employ to reduce or mitigate risk.  That is, there are things you can do, to combat or work around the Market’s uncertainties.  The strategy of "hedging" is one way to do just that.   
 
The act of hedging then, can be seen as insurance or downside protection for your capital.  
 
I should be clear here, hedging doesn't guarantee that you won't lose money -remember, there is no guarantee in investing- however, if used strategically, it can provide some protection.  Or at minimum, provide you nights of sleep.  ​

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​Examples of hedging?

It is a known fact, that retail is performing poorly as a sector.  Even with those statistics, there are some retail companies that are doing well.  As an investor, your job is to find companies that are doing well and well, invest in them. 
 
Let’s say for example you wanted to invest in a retail company like, Adidas (ADDYY) that is doing well.  You would long shares of Adidas (ADDYY) and to protect yourself from the industry risk (remember, retail in general is doing poorly), you could do several things. 

1.  You could hedge your long position by going short the entire retail sector via an ETF like XRT; or 2. you could go short a retail company, like Macy’s (M) that is performing poorly.  
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In the example above, if the retail sector underperforms, you make money on your ETF and Macy's short; however, lose out on your ADDYY long.  If Adidas continues to perform well and doesn’t trade with the industry, you make money on both your ADDYY trade and your Macy's/ retail ETF short. 

​Put simply, going short Macy's (M) and XRT is providing you insurance in the event your Adidas trade (despite it being a fundamentally sound company); tanks with the overall retail sector.   Look below for the performance of both Macy's (M) and Adidas (ADDYY) over the same time period. 

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Adidas chart Since 2015

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Macy's chart since 2015

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ShortMeTina Porfolio Example of Hedging

It is no surprise for anyone that is a part of ShortMeTina's infrastructure that I was an advocate of going long the SPY mid last year at a low of around $202.  That proved to be a good strategy as the S&P 500 (SPX) continues to make all-time highs; netting anyone who listened +20% on their trade. 
 
Leading up to France’s presidential election; I advised premium members that while I remained bullish with the stock market overall; I expected some volatility to occur and perhaps a slight pullback.  I didn’t think it made sense to let go of the SPY (long) but wanted to protect gains and I did this by hedging our mainly long portfolio by buying XLU (utilities ETF).  It is known that when the Markets become uncertain individuals run to safety plays such as utilities (XLU) and staples (XLP), among other things.  This proved to be a good strategy as XLU saw a gain of over +7% during that period of market uncertainty.  The ETF has since pulled back, perhaps signaling some certainty within the market. 

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SPY chart April/2016-present

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XLU chart during France Presidential Election

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Another Example of Hedging ​

I tend to hedge my long positions with put options or my short positions with call options when going into earnings.   Stated differently, purchasing options on a stock you own can minimize downside risk.  
 
Let’s say, I own 100 shares of Tesla (TSLA).  From the company’s December 2, 2016, low of $180; the company’s stock has appreciated 100% in less than a year.  Even if you believe in the company’s prospects going forward, with such a strong move in such a short period of time, as opposed to selling your shares in Tesla, an investor can buy one put option.   By purchasing puts, if the stock pulls back or dips –you make money.   If the stock continues to go up, you simply do nothing and have your puts expire worthless.  The only cost to you for your ‘protection’, is the premium you purchased. 

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