Imagine this scenario, you just got hired as a developer for a company that works for the edge funds industry. You know nothing about edge funds. Sure enough, you use cutting-edge technologies and think about edge cases.
Determined to do a great job, you start studying what this is all about. Not even thirty seconds into the quest and you realize your Italian brain doesn’t process the letter h.
Of course, all characters appearing in this story are fictitious. Any resemblance to real persons, living or dead, is purely coincidental. And by that I mean that’s exactly what happened to me.
After learning how to spell hedge the next step was to learn what it means.
If you invest you expose yourself to a certain amount of risk. When you bet some money on one investment there’s always a chance you’ll lose. If you try to reduce the risk of one investment by investing in a related position you are hedging.
The word hedge indicates
a way of protecting, controlling, or limit something. In this case, you are protecting yourself from a possible bad investment. There are different ways to hedge, we’re going to see the long/short equity model.
When it comes to name the first hedge fund many state A. W. Jones as the father of the industry. Jones launched his fund in 1949 deciding to use the long/short model to hedge risk. For this reason Jones was calling his fund a hedging fund.
During the 60s—as hedge funds were gaining popularity—hedging became hedge despite Jones himself didn’t like the new term.
Nowadays, hedge funds use different strategies, and not all hedge risk. Still the name remained.
Imagine that shares for Acme Inc. cost $2 each. You think they’ll perform well in the future, so you buy 1,000 of them for a total of $2,000. After one day, your prediction turns out to be correct. The price for one share is now $2.2 and your 1,000 shares are worth $2,200. You earned $200.
Buying stocks hoping that they’ll increase their value is called a long position. In the previous example, you had a long position in Acme Inc.
Of course, you have no guarantee that Acme shares will increase their value. So you want to have a safety net in case things don’t follow your plans.
Ajax Inc. is a competitor of Acme. You assume that Acme is a stronger company and its shares will gain value faster. This characteristic is used by the long/short model to hedge the risk involved in investing in Acme.
Back to our example, you not only buy $2.000 worth of Acme shares you also borrow 2,000 Ajax shares at $1 each. Remember, you think Acme will increase its value and Ajax will lose value. So why borrowing $2,000 of Ajax? Immediately after borrowing those share you sell them. In this case, you have a short position on Ajax Inc.
Long/Short in Action
We already saw that after one day Acme sell to $2.2 a share. Ajax grows as well but slower and on the second day one share is worth $1.05. This means that when you’ll want to buy back your 2,000 Ajax shares you’ll have to pay $2,100.
One one hand you earned $200 but on the other, you lost $100. You still gained $100 but so far your short position doesn’t make much sense.
On the third day markets are troubled, most stocks are losing money. Acme price goes down to $1.9. Ajax is not so strong and loses much more going to $0.70 for one share.
Your Acme shares are now worth $1,900 resulting in a loss of $100. This is where your short positions on Ajax come to the rescue. To buy back 2,000 Ajax shares you now have to pay only $1,400. This leads to a gain of $600.
Let’s review the values.
|Day||Acme $/share||Acme Shares Value||Ajax $/share||Ajax Shares Value||Total Balance|
As you can see, thanks to hedging, you earn money when your prevision is correct—Acme Inc. will increase its value—and when it’s not.
Of course, we can’t avoid risk completely. Imagine if Ajax shares were to go up and Acme’s to go down, your loss would have been huge. For the long/short equity model to work investors still have to make a difficult call. They have to decide which positions will perform better than others.