There are many ways a trader can attempt to minimize risk. Hedging, diversifying, or a combination of the two require a deeper explanation of each.
On this week’s podcast, we'll unpack these two fundamental concepts.
First, let’s explain the concept of correlation so you can better understand the strengths and weaknesses of hedging and diversification.
Correlation is a historical measurement of how two securities have moved together in the past.
Correlations range between -1 and +1.
A -1 correlation implies that two assets move perfectly opposite of one another. Historically, as one asset went up, you would expect to see the other asset go down.
A +1 correlation implies that two assets move together.
Zero correlation means the two move independent of one another. Investors typically look for zero or low correlation when hedging or diversifying.
However, investors wrongly assume that correlations are static and predictive of future market conditions. Correlations can break down in an instant and send two stocks in entirely different directions.
Volatility clustering demonstrates how previously uncorrelated securities can experience volatile price changes simultaneously when market volatility increases. Assets moved together when the market went through periods of high volatility, reducing or eliminating the benefits of diversification on previously uncorrelated assets.
Learn more about correlations and volatility clustering with Podcast Episode 181.
It is important to examine historical correlations to understand how two different assets moved in relation to one another, even if their past movement is not indicative of future behavior.
When you think of hedging, you should think about a hyper-focused risk reduction event, where you're offsetting risk for a specific event, outcome, or time.
Home insurance is an excellent example of hedging. When you buy a house, home insurance is a hedge for future uncertainty. It doesn’t eliminate the potential destructive event, but it offers a financial safeguard for a specific outcome. Medical bills, hospital visits, and medical emergencies are not covered because home insurance is hyper-focused and tied to a single asset class.
Trading offers many ways to hedge stock and options positions. You can buy long option protection if you’re short an options contract.
An iron condor is a perfect example. To offset the risk of a significant move and unlimited loss, you can purchase options to define your risk.
When hedging an asset in a portfolio, you are trying to invest in products with a strong, predictable, inverse correlation. The goal is to look for securities that have a -1 correlation. The assumption is that if one asset goes down, the other will go up and offset the loss.
There are many ways to think about diversification. Ultimately, it is an opportunity to reduce risk across your portfolio by strategically investing in different asset classes, underlying securities, and timeframes.
You must intelligently use the current information you have about correlations when making decisions, which doesn’t guarantee success, as we’ve discussed.
The goal of diversification is to try and find as many combinations of uncorrelated assets as possible.
Diversifying is a costless opportunity that you can take advantage of without sacrificing the potential for higher gains, unlike hedging, which typically has an associated costs because one asset loses value while the other gains value.
The problem with diversification is most investors think it's driven by quantity, and simply adding more products to a portfolio creates diversity. That is not the case; you must focus on uncorrelated assets.
Picture an ice cream shop that sells ice cream in the summer. They decide to sell Christmas trees in the winter. Selling ice cream has nothing to do with selling Christmas trees. If they sell less ice cream, that doesn't necessarily mean they will sell more Christmas trees.
The owners have added a product mix to their portfolio to diversify and increase their returns and potentially reduce their risk of going out of business in the winter months when they can't sell ice cream.
Conversely, selling chocolate and vanilla ice cream is not a good diversification strategy because the two products are highly correlated.
The trading equivalent of adding chocolate ice cream would be buying Coke and Pepsi. While they’re not the same company, the performance of the two is most likely highly correlated.
The key when diversifying is adding highly uncorrelated assets to your portfolio, not negatively correlated assets.
How to Bring Hedging and Diversifying Together
Now that we understand hedging and diversifying, we can have a high-level discussion on how they work together. Can you do one and not the other? Should you do both? Should you do neither?
Statistically, research shows that having some diversification is a good idea.
Investors often choose only to diversify and not hedge inside their portfolios. (Most investors probably think they are hedging but are really just diversifying).
The beauty of options trading is that you can do a little bit of both. You can use diversified underlying securities in a basket of options trading strategies and hedges throughout your portfolio.
You can hedge individual strategies and position types and hedge across different timeframes with different asset classes.
Remember, when markets experience high volatility, correlations begin to converge, and the benefits of a diversified portfolio suddenly fall away.
Of course, there is no perfect approach. You can never diversify completely because correlations are not static, and the activities of market participants impact correlations. It is also nearly impossible to find a perfect hedge that minimizes all potential risks without forfeiting some or all potential profit.
So, we can't perfectly hedge, and we can't perfectly diversify. So what’s the answer?
We must continue to work toward an objective outcome and make smarter trades with the information available.
“Shawn: Hi, my name is Shawn. My question is, why do stock chart patterns actually work? How does a chart actually represent, or equate to, an increase or a decrease in the price of a stock?”
Check out our Handbook section on Chart Patterns.