The actual design of a hedging strategy boils down to a simple, three-step process:
Identify Suitable Securities
A good hedge often uses the cheapest possible security that offers the protection needed. For example, in the retail situation above, using put options on the retail ETF may be cheaper than purchasing a full short position, while offering the same benefits as the more expensive alternative.
Check the Correlation
Correlation is very important to consider, as any variance equates to additional unmitigated risk. For example, using gold as an inflation hedge may be less correlated to inflation than using a tips ETF or other similar securities. After all, any movement in gold that’s not tied to inflation could mean additional downside.
Determine the Value
A hedge’s total value must always match the value of the underlying position in order to completely isolate an investment idea. Going back to our retail example, the total value of the retail ETF short position matched that of the long position in the retailer in order to completely offset any decline in the retail sector. However, the positions can be adjusted as needed, depending on situation and sentiment.
Effective hedging strategies can help individual investors mitigate risk and isolate opportunity in much the same way that professional investors protect their investments. However, it is important to double-check these hedges and think through the strategy in order to ensure that they will function as expected and help enhance returns in your portfolio.