Hedging 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 purchasing stocks with offsetting betas. Conversely, delta hedging is an options strategy that reduces the risk associated with adverse price movements in the underlying asset.

Key Takeaways

  • Savvy investors often use hedging strategies to reduce their portfolio risk, but knowing which type of risk to reduce will dictate the hedging strategy.
  • Beta hedging seeks to remove unsystematic risk from a portfolio so that it has a beta equal to 1.0.
  • Delta hedging removes directional risk and is used primarily by derivatives traders to isolate changes in volatility.

What Is Beta Hedging?

Beta measures the systematic risk of a security or portfolio in comparison to the market. Systematic risk is that risk inherent with investing in the stock market and cannot be hedged away. While systematic risk can be thought of as the probability of a loss that is associated with the entire market or a segment thereof, unsystematic risk refers to the probability of a loss within a specific industry or security.

A portfolio beta of one indicates the portfolio moves with the market. A portfolio beta of -1 indicates the security moves in the opposite direction of the market.

Beta hedging involves reducing the unsystematic risk by purchasing stocks with offsetting betas so that the overall portfolio has the same general riskiness as the S&P 500 broad market index.

For example, assume an investor is heavily invested in technology stocks, and his portfolio beta is +4. This indicates the investor's portfolio moves with the market and is theoretically 400 percent more volatile than the market. The investor could purchase stocks with negative betas to reduce their overall market risk. If they purchase the same amount of stocks with a beta of -4, the portfolio is beta neutral.

What Is Delta Hedging?

Unlike beta hedging, delta hedging only looks at the delta of the security or portfolio. Delta hedging involves calculating the delta of an overall derivatives portfolio and taking offsetting positions in underlying assets to make the portfolio delta neutral, or zero delta.

This means that the position is directionally neutral - if the underlying asset goes up, the hedge goes down in turn. This strategy is most often used by derivatives traders who use options to trade volatility or correlation strategies such as dispersion, rather than direction.

For instance, assume an investor has one long call option on Apple. As an historical example, on August 30, 2018, Apple has a beta of 1.14, which indicates Apple is theoretically 14 percent more volatile than the S&P 500. The investor's position has a delta of +40, which means that for every $1 move in Apple's stock, the option moves by 40 cents. An investor who delta hedges takes an offsetting position with -40 delta. However, a beta hedger enters a position with a beta of -1.14.