Hedging and shorting

[Seany88]

Can anyone give the basics of hedging a position by shorting a stock? How do you decide how much to short by...should it be equivalent to your long position?

[g4ry13]

Person x has a long position holding stock worth £1,000,000 for every penny movement he's liable to see a £1000 change in his p&l account (i'll keep it simple with imaginary numbers.) Person X becomes concerned that his long position is at risk as he doesn't feel too good about the current economic climate or is concerned about a trading statement or some results etc. so decides to hedge their bets by covering themselves in the short term by taking a short equivalent to £1000 for every penny movement. So now if the price goes up or down person X is able to maintain a neutral position in his p&l account and the loss he incurs will be the spread + any other transaction costs.

Personally, it seems a little silly because if there's doubt over a stock one should get out and re-evaluate if required. Alternatively, one can hedge against other stocks. eg Mining stocks. Going long on Rio Tinto and short on BHP Billiton (assuming the 2 stocks move in a similar fashion.) But I guess the first paragraph is more relevant to what you initially asked.

Edited by g4ry13 on Thursday 25th September 11:36

[Seany88]

Ok, but then say their focusing on a volatile stock, by my understanding they would get the best out of both worlds without needing to dip in and out i.e. by selling stock when it hits the top of their target range, and closing the short at the bottom of the range. Is that feasible?

[g4ry13]

Are you sure you're not talking about straddling rather than hedging?

[Seany88]

I don't know...can you explain the difference?

I understood hedging to be covering yourself in the event that it goes the other way?

[g4ry13]

Ok, in a hedge the aim is not to make money. It's just to reduce or even cancel out your risk so you don't lose money in the asset you're long/short on. It neutralises your position according to the price fluctuations.

The straddle is mainly an options strategy. Essentially they'll take two positions in opposing directions to the market and if the market is volatile and moves enough then they'll turn a profit and cancel out the loss from the losing side. You can read more about it here

prepares to be flamed

[Seany88]

g4ry13 said:

Ok, in a hedge the aim is not to make money. It's just to reduce or even cancel out your risk so you don't lose money in the asset you're long/short on. It neutralises your position according to the price fluctuations.

The straddle is mainly an options strategy. Essentially they'll take two positions in opposing directions to the market and if the market is volatile and moves enough then they'll turn a profit and cancel out the loss from the losing side. You can read more about it here

prepares to be flamed

So why would you attempt to neutralise your position? Other than for the obvious (stop losing money)? Because once you've set up the hedge what happens after? When do they decide to turn it into a straddle and turn a profit?

[apguy]

Seany88 said:

So why would you attempt to neutralise your position? Other than for the obvious (stop losing money)?

The hedge may be a side-issue from your main trade.

For example, if I do a Swap with an overseas client and they pay me in dollars for the life of the swap then I have an fx exposure (the $ vs £ rate can change) that can be negated by hedging against the $/£ fx rate.