This isn't strictly math, but question about hedging investments

[dmatador]

I hope someone will give me some of his/her time and help me understand this--and given the platform, I'd say the more math in your explanation the better. I am having some trouble understanding a particular type of hedging ones investments: say that company X is going down the tubes and you decide to short some bonds of company X. But, perhaps, to hedge your investment you also buy long some shares of company X. What is the benefit of doing this? My thinking is that you aren't really gaining anything, unless you pick a calculated time when the company is on the rise or continuing to fall and decide to drop the appropriate investment. Does this make sense to anyone? Please, spill your knowledge onto me.

 

[Bill Simpson]

This tries to explain the situation based only on perceived and "actual" uncertainty. Suppose other investors overestimate their skill at predicting the direction of a particular stock and underestimate the uncertainty of the future price. Some recent authors claim this is true. Then in your example the stock will be sold for more than its actual value and the hedge for less than its actual value. If you believe that others are underestimating the uncertainty then you can profit on average from their mistake. Nassim Taleb in his book "Fooled by randomness: the hidden role of chance in life and in the markets" unfortunately includes not a hint of mathematics anywhere, but if you try to guess what he is not saying in the book then this strategy appears to be what he is doing. He describes buying options on both sides of a stock for somewhat extreme strike prices, these are deeply undervalued because he claims others in the market seriously underestimate the uncertainty, he never exercises most of these cheap options and thus throws away the price he paid for them, but he does exercise some of them and makes large profits overall. But once a strategy has been published I suspect that at least some have immediately begun to take advantage of this and diluted the potential profit.

Now put some mathematics into this. Built a little Monte Carlo model, choose the herd low value for uncertainty and a higher actual uncertainty, find some plausible way to price the stock and hedge, run the model a few thousand times and see whether you have a positive or negative return after your costs.

Caution: I know almost NOTHING about the stock market. My only exposure is a modest retirement fund from a company I once worked for. That company sold the fund to a management company. The management company was prosecuted for fraud and I believe the company that took over for them was also prosecuted for fraud. But I accepted that all that money would be stolen and I would never see a penny long before any of this happened.

 

[robert Ihnot]

I have sometimes, years ago, accidently wound up being both long and short on a stock. (This also depends on the broker some, it seems, are not supposed to allow this.)

There would almost never be a real good reason to do this. The simple fact that under the circumstances of 100 long and 100 short, the value of the stock does not change. The question of what to do now is quite speculative.

 

[G037H3]

There would almost never be a real good reason to do this.

Completely untrue. The introduction of leverage makes hedging a great way to manage risk.

 

[dmatador]

Go on...

 

[CRGreathouse]

Completely untrue. The introduction of leverage makes hedging a great way to manage risk.

You give me a time you'd want to be long and short on a stock, and I'll show you an equivalent position that costs less in broker fees. :tongue:

 

[dmatador]

The last two posts come with the implication that the people behind them have some knowledge about the sort of stuff mentioned in my question. So, either you are not answering my question for some other reason, or you are just talking bull. In either case I am a little aggravated.

 

[G037H3]

The last two posts come with the implication that the people behind them have some knowledge about the sort of stuff mentioned in my question. So, either you are not answering my question for some other reason, or you are just talking bull. In either case I am a little aggravated.

I made over 10% annualized with options doing nothing when I was 18. o.o There are plenty of resources that discuss hedging. YOU seem to make a LOT of assumptions.

 

[dmatador]

I am aware of the resources on the internet and elsewhere, but this is a somewhat more specific problem. Also, I enjoy reading the feedback of the smart and friendly people on PF, and I definitely prefer it over some boring online financial resource. Nevertheless, you seem to be unable to help me. And congratu****inlations on your financial success. I really really care.