What is Hedging? A short tutorial on what hedge funds do.

Whether or not you trade stocks on Scottrade or are considering investing in the future, it’s likely you’ve heard of “hedging” (as in “hedge fund”) as a trading strategy. Hedging is simple and extremely lucrative for both casual traders and large investors alike. In fact, almost any trading strategy can be motivated as some kind of hedging. In this brief tutorial, I’ll provide an example of basic hedging using data on energy firms from summer 2015. This tutorial contains no math and is therefore appropriate for a general audience. However, there is some finance jargon used (all of which can be quickly googled).

Before proceeding to discuss hedging, it is important to keep in mind the concept of stationarity. Very roughly, data is said to be stationary if it exhibits no visible trend; when the data appears to simply be noise. Consider the following two examples

It’s clear that there is an upwards trend in the lower plot, implying non-stationarity. Certainly, trends can be much more nuanced, making statistical tests—such as the Phillips-Perron Test—preferred to graphical methods. Stationarity is nevertheless important as it implies that the past will repeat itself. The goal of hedging is two-fold: (1) to somehow construct a portfolio that exhibits an upwards trend by combining several stocks that may not individually exhibit a clear trend and (2) to combine several risky or volatile securities in a way that increases portfolio stability.

For clarity, consider the following example. Lately, oil firms, like OXY (Occidental Petroleum Corporation), have been suffering due to instability in Middle East caused by ISIS, the refugee crisis, etc, allowing alternative energy corporations, like HFC (Holy Frontier Corporation), an opportunity to perforate the energy sector. This suggests a trading strategy in which we buy shares of HFC and sell short OXY. A graphical depiction of this strategy follows, where we use data on both companys’ stock prices from 5/27/15 to 9/27/15.

We can see, in the left plot, that between June and the end of September, both stocks have appeared to move in opposite directions. Namely, it appears that OXY is declining while HFC is on the incline. The trend, however, does not appear to be extremely stable—we can see significant convulsions in both securities, particularly in mid-August. In the right plot, however, we can see that the portfolio constructed by buying HFC and selling OXY exhibits a more stable trend meaning that the portfolio is less risky than trading each stock individually. Not only this, but the portfolio’s upward trend appears to be steeper (in magnitude) than that of its constituent securities.

Diversification is one example of hedging. By selecting this portfolio, we are able to significantly reduce idiosyncrasies that exist in each security, distilling the greater market trend in the energy sector. Other forms of hedging aim to achieve market neutrality, which means even further mitigating the systematic component of the portfolio’s performance. Selecting stocks that bear a similar relationship as OXY and HFC can be described as both an art and a science. It is an art in the sense that political and macroeconomic reasoning can be used to rationalize the potential co-movement of several sectors, industries, or firms. And in the case of science, modern computational statistics (like machine learning) can be used to identify several securities that appear to move together or move in opposite directions. One such example of the latter is Google Correlate.

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