How hedging your bets can be useful

by Cre8or_1

 

Here’s an example of when a hedge can be useful:

You own a lot of SPY (S&P500 ETF) shares. Now you are afraid of a downturn, instead of selling now and rebuying your shares later (which costs you fees & taxes on gains you had), you buy some OTM puts. This protects you against rapid downturns for a fix amount of money, while barely limiting upside.

Another example: You want to short a stock. But shorting a stock has the potential to go “tits up”, your potential loss is infinite. For a small price you can buy some cheap OTM calls as a hedge, limiting your max loss to a high – but finite – amount.

Another example: selling covered calls is essentially selling part of your potential upside for a fix amount of money and can be considered a hedge

More theoretical: Think about stocks less in a way of “goes up or goes down” and instead think of investing as a function that maps the stock price to your returns. The “normal” investing function is the identity, meaning your return scales linearly with a factor of 1 from the stock prices changes. But depending on your investment strategy (options, leveraged ETFs, buying and selling), your function can look vastly different. Selling a covered call and using that money to buy a put on your stock reduces possible gains and also reduces possible losses, it kind of makes the graph of your function look ‘flatter’ if that makes sense – less volatile. (If I could draw you a picture and explain it Iam sure you would understand immediatly).

hedging can be used to tweak your function of stock-price changes –> returns, mostly you tweak the extreme cases of huge stock price changes in either direction.

You can also hedge against inflation, in this case the ‘function’ I talked about would be a function that maps inflation to your returns

or you could hedge against an event, like a rate cut or sanders becoming president.

 

Disclaimer: Consult your financial professional before making any investment decision.