Hedging
Strategy
The Most Effective Hedging Strategies
There are several effective hedging strategies to reduce market risk, depending on the asset or portfolio of assets being hedged. Three popular ones are portfolio construction, options, and volatility indicators.
Hedging
Key Takeaways
Risk
Market risk, or systematic risk, is the possibility that an investor will see huge losses as a result of factors that impact the overall financial markets, as opposed to just one specific security.
Modern Portfolio Theory
Modern Portfolio Theory is one of the tools for reducing market risk, in that it allows investors to use diversification strategies to limit volatility.
Options
Another hedging strategy is the use of options, which allow investors to protect against the risk of big losses.
Market Volatility
Investors can also make trades based on market volatility by tracking the volatility index indicator, the VIX, often referred to as the “fear index,” due to its tendency to spike during periods of greater volatility.
01
Modern Portfolio Theory
Modern Portfolio Theory (MPT), which uses diversification to create groups of assets that reduce volatility. MPT uses statistical measures to determine an efficient frontier for an expected amount of return for a defined amount of risk. The theory examines the correlation between different assets, as well as the volatility of assets, to create an optimal portfolio.
02
Options
Investors seeking to hedge an individual stock with reasonable liquidity can often buy put options to protect against the risk of a downside move. Puts gain value as the price of the underlying security goes down.
03
Volatility Index Indicator
The Volatility Index Indicator (VIX) measures the implied volatility of at-the-money calls and puts on the S&P 500 index. It is often called the fear gauge, as the VIX rises during periods of increased volatility. Generally, a level below 20 indicates low volatility, while a level of 30 is very volatile.