In layman's terms, hedging is using one investment to offset another to avoid a large loss. Most individual investors do not hedge their trades or portfolios, but it can be a worthwhile endeavor. Using hedging strategies in the stock and options markets can minimize your risk and still allow you to profit from explosive moves. Beta hedging is when you use one (or several) stocks to offset the movement of other stock market positions. Delta hedging is employed in the options market, creating a position immune to small fluctuations in the underlying stock. Both forms have specific advantages and disadvantages and can be utilized to achieve different objectives in their respective markets.
Not all stocks move together, and that means you can use one stock to hedge another. Beta is one way to determine how stocks move in relation to each other. If a stock has a beta of one, its volatility is similar to the benchmark index, such as the S&P 500. A beta of negative one means it moves opposite to the index, but has similar volatility. Assume you have a very volatile stock with a beta of four. Buying a stock with a beta of negative two will offset half of the volatility of the first stock. If you hold equal amounts of the two stocks the combined beta is two, or half of the original volatility exposure.
Pros and Cons
Hedging with beta isn't tough to do, and it can balance the risk you take in a few stocks or an entire portfolio. Beta statistics are not static though. This means using a beta hedge may require constant adjustment as stocks fluctuates and their beta values change. Beta is a volatility measure, but not necessarily a performance measure. If the benchmark index goes up 10 percent, and you're holding a stock with a beta of one, there is no guarantee the stock will rise by exactly 10 percent. This can be positive or negative as your portfolio may outperform or under perform the benchmark.
A delta measure reflects how sensitive the price of an option is relative to the price of the underlying asset. Delta hedging is also referred to as a "delta neutral" strategy. This is where you structure an options position that won't fluctuate with small changes in the underlying stock price. As long as the underlying stock is only making small moves, the position has no directional risk or bias. Static delta hedging is when you create a position with an initial delta of zero and let the position unwind. Dynamic delta hedging is when you actively manage the position, continually adjusting the delta back to zero.
Pros and Cons
Delta hedging is useful when you believe a big move is upcoming, but you're not sure when. Since it only removes the directional risk of small moves in the underlying stock, you can still profit or lose money if that stock makes a big move. Fees can make dynamic delta hedging expensive if you need to continually adjust your positions, but your position will remain delta neutral. Static delta hedging usually costs less in fees because the position is not actively managed, but the position may not always be delta neutral.
Cory Mitchell has been a writer since 2007. His articles have been published by "Stock and Commodities" magazine and Forbes Digital. He is a Chartered Market Technician and a member of the Market Technicians Association and the Canadian Society of Technical Analysts. Mitchell holds a Bachelor of Management in finance from the University of Lethbridge.