An idiots guide to investing

Hi,

Part 5 - Hedging

Okay, a short entry coming up today on the art of "hedging", which gives rise to the term "Hedge funds". Strictly speaking of course, this little foray into explaining hedging isn't actually going to be practically useful to the average private investor who's reading this guide looking for a step-by-step guide to investing, but hey, its a topical subject and the concept is a brilliant one to get your head around.

Right, to demonstrate hedging, I think an example should suffice: Lets say that this sinusoidal curve is actually the graph for a stock. and now lets assume that we are currently at the coordinates (pi, 0) with the graph heading upwards. Now we can see that the graph is moseying along nicely in a fairly regular pattern so can assume that this will continue. So what a normal person would do at this point normally is to buy in and then sell as the graph reaches its peak.
But a hedge fund is much cleverer than that. they want to make a profit without betting on hunches, so they hedge their bets by buying the stock as well as shorting the stock at the same time...
[What is "shorting"!!? I hear some of you scream. This process will be explained properly at one of the more advanced points in the guide, but suffice to say for now that all it means is that a person who holds a "short" contract on a stock will profit if the stock goes down in price.]
...But all this will mean is that they will continue along without profit or loss as the longing (buying with the expectation of a rise in price) and shorting of the stock will cancel each other out. Ah, you would think that but hedgeys are cleverer than that. They wait until the two respective long and short positions reach their maximum value, then sell them.
So at the peak at the top, the long value will be at its peak profit, and the short position will be at its peak loss - so they close out their long position at the peak, and as the graph declines to a trough again, they wait...and when it gets to the trough, their "short" position is now in profit, so they close that out here too. In other words, it didn't matter where the stock went, the hedgey's were in profit.


This is just one example of hedging. It comes in many shapes and sizes, but the principle is the same - and its a principle we need to engrave on our hearts. ALWAYS THINK THAT YOU WILL BE WRONG AND PLAN FOR THE WORST.
If you do that...well can it get worse than the worst that could happen? of course not, so if you prepare for that, you will survive.

Okay, and now for my recommended book to buy for this week...

Fear, Greed and Panic: The Psychology of the Stock Market (Finance & Investments)

Fear and greed are the things that drive the market, infact some people go as far as to say that the market is actually not a reflection of value but of the human emotions of fear and greed. Those graphs are actually mapping humanity at its worst in other words. Self awareness is vital for success in the market. Its actually less about skill, than about being in control of yourself and keeping your nerve. So buy that book!

The Guide so far:

1. The basic introduction

2. Choosing a stock

3. the tools of the trade

4. managing risk

5. hedging (this post)



My new trading book that takes you through money-making step-by-step:
http://economicsguide.blogspot.com/2010/05/why-i-wrote-trading-guide-to-sell-then.html