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To wit, doesn't hedging necessarily break even or lose money? I assume the semi-strong form of the EMH, defined in Zvi Bodie, Alex Kane, Alan J. Marcus's Investments (2018 11 edn). p 338.

      The semistrong-form hypothesis states that all publicly available information regarding the prospects of a firm must be reflected already in the stock price. Such information includes, in addition to past prices, fundamental data on the firm’s product line, quality of management, balance sheet composition, patents held, earnings forecasts, and accounting practices. Again, if investors have access to such information from publicly available sources, one would expect it to be reflected in stock prices.

Examples

  1. Wikipedia's example of hedging a stock price nets you only 'a profit of $25 during a dramatic market collapse', but it overlooks trading commissions and transaction fees.

  2. Unlike example 1, now presume the absence of any complement. How can this example possibly profit you? If it can, wouldn't algorithmic trading have arbitraged away any profit?

"Say there's 20 minutes to the close of trading," he continues. "If I'm long the call and it's at 95 1/2 I can do two things: I can exercise those calls and buy the stock. Or I can try to sell those calls at a discount in the trading crowd, and in the meantime, just to protect myself, sell the stock short at 95 1/2 myself."

3 Answers 3

1

The Pairs trading example in the Wiki article is terrible. Just because you short 1/2 as many shares at twice the price doesn't mean that the positions will behave linearly. And even if the two companies are highly correlated because they are in the widget industry, what prevents share price of the short position from rising when the share price of the long position drops? You then lose on both sides. I have done a lot and continue to do such Pairs trading but you need a far better reason than share price of A is twice that of B.

Forget about commissions in this situation. If the trade has merit, you do it. What is omitted from the explanation is the carry cost of the short position (the borrow rate) as well as the paying out the dividend on short shares. Technically, the share price adjustment on the short shares is a quid pro quo but there's often additional movement leading up to and after ex-div.

As for this statement in the Wiki link:

If the trader was able to short sell an asset whose price had a mathematically defined relation with Company A's stock price (for example a put option on Company A shares), the trade might be essentially riskless. In this case, the risk would be limited to the put option's premium.

Another horrible conclusion. The only riskless strategy is an arbitrage position like a conversion, reversal, box spread, etc. Puts cost money. There are no free lunches. The put has a cost (the time premium) and there's a deductible if the underlying's price is above the put strike (additional loss).

And last of all with XYZ at $95

"Say there's 20 minutes to the close of trading," he continues. "If I'm long the call and it's at 95 1/2 I can do two things: I can exercise those calls and buy the stock. Or I can try to sell those calls at a discount in the trading crowd, and in the meantime, just to protect myself, sell the stock short at 95 1/2 myself."

ITM options tend to trade below intrinsic value at expiration. In this case, at $95.50 the $95 call has 50 cents of intrinsic value. The quote might be $0.40 x $0.60.

There's no incentive for the market maker or another trader to give you fair value. You can take the 10 cent haircut or you can execute the discount arbitrage yourself. Short the stock at $95.50 and the immediately exercise the call. Short the shares first because that locks in the arb. Otherwise, you can give up some of your intrinsic value if you exercise first and share price drops before you can execute the short position.

1

I don't quite follow all of the thought process or threads, but to answer the root question, hedging is not about profiting, it is about reducing risk. If I'm an airline, part of my cost is jet fuel. If the price of jet fuel goes up, my expenses are higher and I have less profit. So I can hedge that risk by locking in a price for jet fuel in the future, and set my budget without worrying about that expense being higher than anticipated. Of course, if the price goes down I may have opportunity cost, but I'm willing to make that tradeoff.

The other examples are all similar - I can make a second transaction that will reduce some risk that I face - I may not actually profit from the trade, but I'm guaranteed not to lose (assuming a perfect hedge). So I either lock in existing gains or stop any further losses.

7
  • Thanks. I removed some quotes to shorten the post: better? 3. But what if the price of your hedge ≥ your airline's revenue? 4. Why are you "guaranteed not to lose (assuming a perfect hedge)"? I agree that you've hedged away the risk, but in the end, you can fail to profit from your options. If so, because hedging removed your profit, you shouldn't have bought options! You should've bought only if you foresaw no need to hedge.
    – user10763
    Apr 18, 2020 at 2:32
  • The airline's revenue has nothing to do with the cost and the reason for hedging. Hedging is effectively throwaway money in order to limit risk. Buying calls to protect against a rise in the price of fuel doesn't remove the profit. The profit is lowered by the cost of the hedge. It's the risk that is drastically lowered which in this case could be something like an oil embargo and the cost of fuel doubles. Apr 18, 2020 at 3:38
  • Hedging does not always have costs. You can buy futures, swaps, or costless option baskets to reduce downside risk. That said, I did clarify that hedging is used to reduce risk to profit, not revenue. 3) you would never pay more for a hedge that what your revenue is, so that's a strawman argument.
    – D Stanley
    Apr 19, 2020 at 16:48
  • If you have a perfect hedge, meaning you know exactly what your jet fuel expense (in this example) will be with no risk because you've bought derivatives that eliminate that risk, then you're "guaranteed not to lose" because you're locked in. If fuel prices go up, the profit of your hedge offsets the loss on fuel purchases. If the price of fuel goes down, you pay less for fuel but lose money on the hedge. Again, you don't necessarily want to profit on the hedge.
    – D Stanley
    Apr 19, 2020 at 16:48
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    @D Stanley - Defining the 'whole point of hedging' does not change the fact that it comes at a cost. While it reduces risk, it also reduces potential gains. That is the trade off one makes when opting to hedge. That is a cost whether it be up front with out of pocket or if the underlying moves in the opposite direction. Apr 19, 2020 at 21:10
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Just because all available information is priced in (not true anyway, but no matter) this does not extend as far as assuming you know enough about every state in the universe to know the future.

Therefore as new information arises prices change.

A good hedge shares certain common underlying value drivers as the asset to be hedged so that if that value driver changes the asset and hedge move in the according manner. If that driver moves in such a way to drive your asset price down then the position you took in the hedge is intended to move in the other direction... And therefore you profit.

This is usually translated into actual hedging either through the exact relationships derived in risk neutral pricing formulae or a loser statistical relationship.

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