What is hedging a portfolio?
A hedge is a strategy that mitigates against the risks to an investment. In many cases a hedge is an instrument or strategy that appreciates in value when your portfolio loses value. The profit on the hedge therefore offsets some or all of the losses to the portfolio.
#1 Diversifying your portfolio
Own assets across all investment categories. There are many different categories of investments, including stocks, bonds, real estate, and international investments. Spreading your wealth across these categories helps protect your portfolio from volatility.
If you invest in only one category, you are at the mercy of the movements of that particular sector. For example, if you have all of your investments in real estate and the bottom falls out of the real estate market, you could lose a substantial amount of money.
Balancing your investments across the board decreases your risk in specific categories simply because you have less invested. You can make up for a loss in one category with a gain in another.
#2: Hedging with a pair trade
Calculate the market value of your position. The market value of your position depends on the number of shares of stock you hold in your long stock and what that stock is currently trading at. Your value may fluctuate depending on how volatile the market is.
For example, if you held 25 shares of Conoco that were currently trading at $40 a share, the market value of your position would be $1,000.
To hedge the full market value of your position, you would need to short $1,000 worth of stock in Shell.
#3: Using options and futures
Consult an investment advisor. Options and futures are more advanced hedging strategies that can be challenging for beginning investors. If you want to hedge your investments, your profile should be actively managed by a dedicated stock broker or investment advisor.
Look for a licensed stock broker who has a solid reputation and plenty of experience managing portfolios similar to yours and larger.
Stock brokers who work at large brokerage firms may have more resources at their disposal to manage your portfolio, but they also may charge higher fees. Interview several brokers and compare to find the best fit for you.