Portfolio Hedging

Trading Risk

There are three types fundamental risks (which are also components of return) associated with trading and investing. The first risk is the corporate risk of the stock your trading (a.k.a. security selection risk) or the specific risk of the commodity or currency. This risk is minimized by either limiting position size or by utilizing stop losses or both. The second type of risk is the sector specific risk (i.e. semiconductor sector for equities or the precious metal commodities). This risk is minimized by limiting exposure within the sector. The third type of risk is the market risk. Every trader and investor is exposed to this risk with every trade. But market risk can be lessened by trading markets that move in opposite directions (i.e. inversely correlated) or more commonly by creating a long/short portfolio.

Long/Short Portfolios

Portfolios that include both long and short positions are hedged against the direction of the market. Theoretically, when the market goes down the short positions will profit and when the market goes up the long positions profit. Of course, in order for the portfolio to be net profitable the gains in one direction have to outpace the losses of the “hedge.” A long/short portfolio might be constructed of long and short pairs (pairs trading). Or it might be constructed of some percentage of short positions (50% long/50% short, 100% long/100% short, or 130% long/30% short, etc.). Or it might simply take a short position in a benchmark index for every long position. This is called an “index hedge.”

Index Hedging

Perhaps the purest and most simple way to reduce market risk in a portfolio is to take a short position in the benchmark index (i.e. S&P 500 or NDX 100) for every long position taken, or vice versa. The returns of the portfolio are lessened only by an amount equal to the benchmark return and the directional bias is removed from the portfolio. For strategies with reasonable returns relative to the benchmark (often referred to as “alpha”), this can be end up being very cheap insurance. Index options, futures contracts, or ETF’s can be used to establish the index hedge.

Pairs Trading

Pairs trading is a portfolio strategy in which a short position is taken for every long position. This results in a market-neutral “pair.” One approach is to choose two correlated assets whose spread has widened from the historical mean. This is a bet on the spread reverting to the mean; however, it might be argued that this type of trade has twice the asset-specific risk since if either asset has any fundamental character change the historical mean is meaningless. Another (in many cases preferred) approach is to marry a long strategy with a defined edge to a short strategy with a defined edge. In this case, you are looking for outsized gains in either trade rather than a narrowing spread.