Please explain "hedging" to me like I'm a 1st grader

[1a2b3cppp]

So I was watching Million Dollar Traders and they're talking about "hedging" their exposure. One example was the guy bought one bank and shorted another bank, to offset his exposure.

Alright, so 3 possible things can happen:

1. Both banks move roughly together and his net P/L is 0 (the same as not taking the position in the first place)

2. The bank he is short goes down and the bank he is long goes up = double profit

3. The bank he is short goes up and the bank he is long goes down = double loss


How is that an advantageous strategy?

 

[traderyin]

He's exclusively playing the fundamental diff. b/w two banks (one with better quality assets and one with subprime assets). The market risk for holding financial sector stocks is "hedge" out because of 1 long and 1 short.

So you go long a "Good" bank and short a "bad" bank. If the banking sector decline as a whole, the bad bank should drop further down than the good bank, so you profit from the spread.

The only scenario where this would not work is when the bad bank get bought by another bank at a premium ( **cough** MER).

 

[ByLoSellHi]

Hedging is an attempt to minimize your losses in case your 'bets' go wrong.

Isn't it really that simple?


Think of the airliner that 'hedges' against fuel prices going higher by locking in at a 'set' price with a supplier for a specific period of time.

 

[seadog]

Hedging is going long something or other, and going short something or other.At the same time.
Pick any combinations, interest rates, gold, futures, hedge your own portfolio.
Could be a time frame hedge, crop disaster, curriencies.
Hope you get the picture.
seadog

 

[1a2b3cppp]

Quote from traderyin:

He's exclusively playing the fundamental diff. b/w two banks (one with better quality assets and one with subprime assets). The market risk for holding financial sector stocks is "hedge" out because of 1 long and 1 short.

So you go long a "Good" bank and short a "bad" bank. If the banking sector decline as a whole, the bad bank should drop further down than the good bank, so you profit from the spread.

The only scenario where this would not work is when the bad bank get bought by another bank at a premium ( **cough** MER).

Oh, I guess it makes a little more sense if you factor in good banks vs. bad banks.

Quote from ByLoSellHi:

Think of the airliner that 'hedges' against fuel prices going higher by locking in at a 'set' price with a supplier for a specific period of time.

Isn't that more like an option?

Quote from seadog:

Hedging is going long something or other, and going short something or other.At the same time.
Pick any combinations, interest rates, gold, futures, hedge your own portfolio.
Could be a time frame hedge, crop disaster, curriencies.
Hope you get the picture.
seadog

I know it's going long vs. short but my original question was "how is that any different than doing nothing?".

Thanks.

 

[crgarcia]

Hedging = a very expensive insurance

 

[Pekelo]

Quote from 1a2b3cppp:

How is that an advantageous strategy?

You made a good observation. There are a couple of problems with hedging:

1. If it is a perfect hedge, you don't lose anything (except commission) but you gain exactly the same, nothing.

2. If it is not a correct hedge, you still could be losing on one side.

3. Eventually to make money, you have to stop one side earlier than the other side and from that point you are without hedge thus your position has the same risk as it had before, when you started hedging it.

 

[lemeeeplay]

Quote from 1a2b3cppp:

So I was watching Million Dollar Traders and they're talking about "hedging" their exposure. One example was the guy bought one bank and shorted another bank, to offset his exposure.

Alright, so 3 possible things can happen:

1. Both banks move roughly together and his net P/L is 0 (the same as not taking the position in the first place)

2. The bank he is short goes down and the bank he is long goes up = double profit

3. The bank he is short goes up and the bank he is long goes down = double loss


How is that an advantageous strategy?

We need to separate the word from the myth.

Hedging became a household word beginning in mid-90s due to the rise and popularity of hedge funds. The irony behind this is that 90% of the hedge funds don’t hedge. They classify themselves as hedge funds so they can bypass the rigorous regulations facing mutual funds. Majority of hedge funds out there are really unregulated mutual funds.

Classical hedging is more like buying crude oil and selling gas as the two markets are intrinsically tied. On the other hand, buying one company and shorting another one isn't really a proper form of hedging. What if one of them goes bankrupt due to mismanagement and the other hits the jackpot due to luck? In other words, the two companies aren't really tied together in any meaningful way.

 

[jsmooth]

Quote from 1a2b3cppp:


How is that an advantageous strategy?

After doing your calculations, you believe that an Option is worth 50 cents....so you buy the option at 40 cents, and "hedge" yourself by going short the stock....once option expiration rolls around you just locked in a profit of 10cents.....an options market maker uses this type of strategy.

Short a convertible bond; long the underlying stock that it can be converted to......a Convertible Arb Hedge Fund strategy.

Long 30 year Bonds; Short 30 yr futures....wait till the prices converge.....Long Term Capital Mgmt...

 

[TraderZones]

unfortunately, none of the above is really the purpose of true hedging. This is too focused on traders eye view of hedging.

The real purpose of hedging allows a buyer or a seller of something to lock in the price of something

For example, Hershey buys a LOT of chocolate and sugar for their candy products. But in the future, if the price accelerates upward, it may be difficult for them to make a profit. So Hershey may go long a number of cocoa and sugar futures contracts at a desired price, which effectively locks in the price.

This is also what Southwest and other airlines do to lock in the price of fuel over a multiyear time span. If fuel soars in price, they may have hedged by purchasing a number of contracts at a known "acceptable" price. The fuel will be more expensive, but they then profit on their long fuel positions.

On the other side, SELLERS of a commodity can short the futures, so they can guarantee the price of what they are selling in the future.