Hedging is what an investor does in order to offset some of the risk on a certain investment or position within a portfolio. We will use a single stock position as an example. So, if you owned 100 shares of ABC stock and were afraid that its value might depreciate in the near term, you could employ a basic strategy designed to protect your investment in case that were to happen. In most cases, you’d pay a premium for this protection much like the premiums one pays for an insurance policy. It’s basically the same concept. Investors are able to buy this “coverage” simply through the use of option contracts. Options are contracts that allow investors to buy or sell a certain stock at a certain price within a certain period of time. Options to buy stock are known as calls and options to sell stock are known as puts. The price or premium for these contracts fluctuates based on the movement of the stock and the amount of time left on the calendar before the option expires. So when the price of a stock declines, put contracts typically appreciate while call contracts would typically depreciate. In getting back to the original example, if an investor thinks that the price of ABC stock is going down, a put contract, (option to sell) would work well here. Assuming the stock price depreciates, the put contract for that stock is actually going to appreciate and in result cover or offset some of the risk of owning the stock outright.
Now there are several types of option strategies that hedge fund managers can use, but this one here is probably the most basic and a good way to understand how these options are used to “hedge” a specific position. Now should the stock go in the other direction, (that being up), the value of that put contract is going to depreciate and possibly expire with little to no value. So in that scenario, the investor would lose on the principal paid for the owning the contract. However, they still own the stock and therefore would be getting appreciation for holding it. Therefore, owning the put option is the “hedge” against the stock.
The hedging activity by "smart money" or institutional investors is available to us via our friends at Sentimentrader. As you can see in the chart below, the "smart money" is currently hedging at a rate similar to that reached at various times in 2007. The higher the number above 1.00, the more hedging by institutions. After dramatically reducing hedging activity at the end of 2010, hedging activity has increased significantly since the beginning of this year. While the markets can obviously continue higher, this increased hedging activity by the "smart money" should be watched as it indicates a more cautious posture by large institutions; or at least a desire to "hedge" their bets.
