Cover is used to reduce the risk of adverse price movements in an asset class by taking an offsetting position in a related asset.
Beta hedging involves reducing the overall beta of a portfolio by buying stocks whose betas offset each other. Conversely, delta hedging is an options strategy that reduces the risk associated with adverse price movements of the underlying asset.
Key points to remember
- Savvy investors often use hedging strategies to reduce risk in their portfolio, but knowing what type of risk to reduce will dictate the hedging strategy.
- Beta hedging aims to remove unsystematic risk from a portfolio so that it has a beta equal to 1.0.
- Delta hedging removes directional risk and is primarily used by derivatives traders to isolate changes in volatility.
What is beta coverage?
Beta measure the systematic risk of a security or portfolio relative to the market. Systematic risk is the risk inherent in investing in the stock market and cannot be hedged. While systematic risk can be thought of as the probability of a loss associated with the whole market or a segment of it, unsystematic risk refers to the likelihood of loss in a specific industry or security.
A portfolio beta of one indicates that the portfolio moves with the market. A portfolio beta of -1 indicates that the stock is moving in the opposite direction of the market.
Beta hedging involves reducing unsystematic risk by buying stocks with offsetting betas so that the overall portfolio has the same degree of overall risk as the S&P500 broad market index.
For example, suppose an investor is heavily invested in tech stocks and their portfolio’s beta is +4. This indicates that the investor’s portfolio moves with the market and is theoretically 400% more volatile than the market. The investor could buy stocks with negative betas to reduce their overall market risk. If they buy the same number of stocks with a beta of -4, the portfolio is beta neutral.
What is Delta coverage?
Unlike beta hedging, delta hedging only looks at the delta of the security or portfolio. delta coverage involves calculating the delta of an overall portfolio of derivatives and taking offsetting positions in the underlying assets to make the portfolio neutral deltaor zero delta.
This means that the position is directionally neutral – if the underlying asset rises, the hedge in turn falls. This strategy is most often used by derivatives traders who use options to trading volatility or correlation strategies such as dispersionrather than management.
For example, suppose an investor has a long call option on Apple. As a historical example, on August 31, 2018, Apple had a beta of 1.36, indicating that Apple is theoretically 14% more volatile than the S&P 500. The position of the investor has a delta of +40, meaning that for every $1 move in Apple stock, the option moves 40 cents. An investor who hedges delta takes an offsetting position with -40 delta. However, a beta hedger takes a position with a beta of -1.14.
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