Hey, this is Shasha and thanks for joining me here for another video lesson about stock trading and investing.
Today's video what I want to do is share with you another frequently asked question that I get on my channel and through emails. Today's problem is "What is the purpose of hedging?"
What is hedging?
First, let's take a look of what hedging means or the word hedge. Typically the root word comes from limiting or often referred to as restricting or confining similar to a garden hedge that acts as a border around a property; you have the same thing in the stock market. There's a little bit of a border, and there could be restricted, some confinement and that's ultimately what you're doing when it comes to hedging in the market.
What's the point or purpose behind hedging in the market? Well, it comes down to watching the risks because investing the stock market it all comes down to looking at your chances and the trades and investments you have on hand.
If you have so much invested in one stock, then you're over leverage in one security or equity or over investing. What you want to do typically is as news or things come out you're looking to hedge, you're looking to confine or restrict that investment, and that's the goal and the point.
If we take a look at this on paper and we start drawing out an investment scenario, let's say you have 100 shares of Facebook, you might have 100 shares of Amazon, so this would be your investments, and then you have another 100 shares of Microsoft.
You can see that all of these are tech companies. If you're looking for tech to explore this are excellent investments as a general concept. But if you want to hedge this, let's say so you assume that technology is going lower then what you could do is hedge this by taking another investment. And let's say something like Exxon Mobil, that's kind of another way to hedge is that now you are looking at sector hedging.
The other approach that you could go ahead and the hedge is something that goes a little bit more against the market or something that's a little bit different. If we had the same type of stocks or investments on this site which could do is you could hedge slightly differently. Instead of doing a hedge with Exxon Mobil you could hedge let's say 100 shares of something like GLD or The Gold ETF again, again this is all just conceptual for educational purposes. I'm just using them as examples which get the idea.
Now, I'm looking at one side is more of a sector hedge, this side is more of doing something that's a little bit inverse to the way the market moves. And of course, you could do ETF or bare sheets you have or something else. Now that you have these two concepts down you could also look at hedging at lot more.
For example, you could see right here in this hedge we only have 100 shares hedged to cover the 300 shares that we own. Right now this is a minimal hedge, what you could do the same thing over here is rather than hedging let's say 100 shares are assuming everything is equal in price and so forth making numbers easy, I could hedge by 200 shares, I could hedge by 300 shares.
If I thought things were in trouble, I could do a hedge by 500 shares whether that's in Exxon Mobil or even over here by Gold. And I could do a fence that's entirely a lot larger than even my holdings or my positions. And with this, does it allow me to look at the market and see if things are going to reverse then at least I'm compensated on this hedge, on the idea that's covering. But basically what this does is this goes slightly against what I usually own to help compensate if things go against me.
One of the great things about hedging is also looking at the time frame. If we take a look at a time frame, you can do a hedge for a shorter time frame, so let's say this is time frame A and this is time frame B and as time moves forward you could do a hedge based on something that's happening in an event.
Let's say something is going to happen over here whether that's interest rates rise, earnings reports something is going to happen in this time frame and you own a stock call it XYZ. As you hold this stock and you approach this time frame where you think things could be a little dangerous, what you could do is now create a low hedge right here and again whether that's Gold, Exxon Mobil something opposite of your XYZ, it could be shorting the market, it could be buying a put, buying a call whatever it is you could get it for just this time frame.
Now it hedges you for this little bit of time frame in case your investments go against you. And then right here you would get out or get rid of that hedge right there and continue using your XYZ. And not as just in case your XYZ position goes lower at least your hedging position goes higher, and it compensates you for that difference. Ultimately that's the goal, so you don't lose as much money from your initial investment.
Of course, every time you put on a hedge whether its right here for a shorter time frame or even a longer time frame it's going to cost you, it's going to cost you time, money, energy and resources. If the stock is going in your favor and XYZ continues to move higher, then this hedge ultimately is going to continue to lose value.
If you overvalue or over a hedge, it can work against you, your goal is to hedge enough to where you're protected but not too much to where it can cause you even more problems. Because otherwise then you'll get whipsawed back and forth.
There you go, I hope to you get some insight regarding some hedging concepts. Of course, this is just a baseline idea about hedging, and things can get a lot more complicated.
Reasons why you hedge
You might be wondering why don't you just put on a stop or continue to raise your stop? Well, the fact is that if you put on a stop or keep raising a stop what if in that one day or that event that stock tanks and goes downtime 10, 20, 50 points because of that event.
That's one of the reasons why you hedge. The other reason is going back and forth on your position especially as you start trading larger getting back in and out its just costly and time-consuming. So you want to protect yourself because your hedge is a lot smaller of work or amount of capital or amount of resources that you need to use to defend your primary position.
If your primary position is let's say 50,000 shares and you might only hedge with let's say 4,000 shares, then it's a little bit more cost effective than getting out of your 50,000 shares getting back in them later, raising your stop and so on. Instead, you're just looking to protect that position.
Hope this makes sense if it doesn't send me an email and I'll explain it to you in a little more detailed. Thanks for joining me in this video if you want to see some of my books then go ahead click this button right here and you'll see some the books that I've written about stock trading and investing.
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