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The idea behind hedging is to create a portfolio of investments that make good returns but are also protected should the market dip. This is the idea behind a hedged (or hedge) fund: all bets are hedged. The risks of one trade are supposed to balance against the risks of another trade. The idea is not to necessarily out-perform the market per se, or to make a lot of money on risky trades but rather the idea is to protect capital and make trades that reduce risk. In a bear market, or one where prices are declining, then the portfolio should hopefully be flat; it may lose, or gain, a little but overall the trades balance to keep the portfolio of investments protected. In the markets we have seen this week (first week of August 2011) there are a lot of people that would be glad to have flat returns rather than negative returns. Such an outcome is possible from hedging your positions.

This article won't review the history of hedge funds or say much about how they operate but rather just stick to how we can set up hedged trades in our portfolio. The aim is to keep it simple for people that are new to trading and investing. Hedging is generally categorized with trading than with investing. I'll use the term trading to mean short term bets, and use investment to mean long term bets.

Hedging can be used as a means to protect investments, it can be used over the long term, although it never seems to appear in any literature on investing (such as value investing). Although that isn't to say that some modern value investors won't use a hedged trade for a smoother performance.

Setting up a hedge trade essentially revolves around buying something (for example, a stock) and then selling something else. The two assets should have fair correlation, that is to say that they both rise and fall together. Stocks, or assets, that are in the same sector will rise and fall together. Example: BP and Shell are both oil and gas producers, their stock market prices should be correlated. If one is having a great year then the other is also likely to be having a great year. If the price of oil rises then both companies are affected (almost) equally, and if the price of oil falls then both companies will also be affected equally. This was certainly true before the oil well disaster; in such a situation then the trade would need to be reassessed.

The part where the hedging is where we buy the stronger of the two companies and sell the other one. Our analysis might reveal that Shell is the stronger company so we go long (or buy) their shares. Consequently, we go short on BP. A short is where we make profit from a decline in share price. The trade set up means that you will lose money on the BP trade but gain money
on the Shell trade. As analysis has revealed: Shell is a stronger company, therefore their share price will make a higher return than BP. If we make up numbers and say that Shell will return 10% over the year and BP return 7% then this trade will make the 3% difference. Might not sound like a lot but the idea isn't really to make outstandingly large returns but rather to protect your capital in all market conditions. This is the elimination of market risk.

If the market falls then both companies will roughly fall together. The trade on Shell will lose money but the short trade on BP will gain money. Again, if our analysis is correct, then BP should fall further than Shell. BP falls further because analysis has revealed that they are a weaker company and so less attractive in all market conditions. Moreover, this type of trade is an example of a spread trade: both companies are in the same sector (oil and gas). That means that if this sector falls (on some oil related news), hence independently of the market as a whole, then our loss in BP will make up for the loss in Shell. This type of trade eliminates sector
risk.

This is also designed to make the returns of the portfolio smoother; the price of the individual stocks may be quite volatile but when one is hedged against the other than the other return (your profit and loss, or P/L) is less volatile (smoother). In the above example, this can be shown by noting that if Shell drops suddenly and eats into your profit, then the short position on BP is also likely to drop quickly and so compensate for the loss. As demonstrated, the market risk and the sector risks are eliminated in such trades. The only risk left is the unique risk, or idiosyncratic risk, of each individual company: such as the oil well disaster for BP in 2010. This risk is where you make the money, if it was eliminated then there wouldn't be any difference between the two companies and hence no spread.

Other examples of such a trade could be to go long oil when the price is rising, and short Shell. If the price of oil is dropping then you could go long Shell but short on oil. Such ideas, or themes, are at the heart of a hedged portfolio. How to generate themes and how to analyse stocks are subjects that are left for other articles.