Simple Hedging Strategies

Hedging can be traced to 350 bc to Greek merchants who initiated the first futures markets for olive harvests. Commodity futures are conceptually intuitive and it makes sense to use these markets to introduce the idea of hedging risk. Ranchers and farmers through antiquity have grappled with the uncertainty of future prices for livestock and produce when brought to market. Their risk lies in the possibility that market prices may fall between the present and some future date when they need to find buyers for their output. With futures markets, they could eliminate that risk by locking in prices today by selling their output forward, using futures. A livestock rancher, for example, may need to drive 1,000 head of cattle to a distant stock yard six months from now. He would like to hedge the risk that beef prices may fall in the interim by finding a counterparty (for example, a meatpacking company) that will agree today to buy those cattle at an agreed-upon price and take delivery in six months. Futures markets make this possible—the rancher, who has a long position in cattle today hedges price risk by selling cattle short in the futures market, that is, by selling (writing) a futures contract for future sale. The counterparty takes the other end of that contract; he is currently short cattle and therefore goes long by buying a futures contract agreeing to pay a fixed price when the contract expires and thereby locking in a buying price. It is possible as well that the counterparty is a speculator (and not a hedger) who bets that beef prices on the spot market will be higher than the futures prices. If they are, then the speculator's gain is the difference between the future market price of beef and the futures price. Hedgers, on the other hand, gain by eliminating price volatility.

Portfolio managers would like to hedge downside risk. The introduction, in 1983, of futures contracts on the S&P 500 made this possible when managers for the first time could sell S&P 500 futures (shorting the contract). If returns were to fall, then the gain from the short futures position would offset the loss on the portfolio. Intuitively, it works like this: suppose you own one share of stock and want to hedge the risk that its value falls by shorting a share of that same stock. The short sale creates a positive cash flow at the current market price. If the value does indeed fall, then so does the price of the shorted stock, which you now buy at the lower market price to cover the short position. The gain on the short position just offsets the loss on the long position. S&P 500 futures made hedging simple for portfolio managers by offering a hedge instrument with comparatively little basis risk in a highly liquid futures market. Without the S&P 500 futures contract, managers would face the task of cobbling together short positions in many different stocks to adequately match the exposure of their portfolios. The mismatch between the hedge portfolio and the portfolio under management is called basis risk.

Basic hedging strategies also use put and call options. Puts formed the basis of the original portfolio insurance products devised by Hayne Leland and Mark Rubinstein in the mid-1980s. Puts give us the option, but not the obligation, of selling all or part of our portfolio at some agreed-upon price (the strike price) at some future date (strike date). Thus, if the value of my portfolio is $100 today and I were to buy a put option that allows me to sell my portfolio for $90 one month from now, then this option hedges the downside risk to no more than $10 in losses. Thus, the put acts like an insurance policy. In this example, the deductible is the $10 in losses after which the insurance contract kicks in, eliminating any further losses. If prices don't fall, I let the option expire.

As we well know, volatility brings with it the risk of losses. A call option on the VIX (the implied volatility on S&P 500 index options) pays off as the VIX rises relative to a strike price, in this case, a preset level of volatility. In general, as volatility increases, then so does our exposure to both gains and losses. Buying a VIX call hedges that risk because the value of the call increases with volatility. We now look at these examples in more detail.