Perfect Hedges: What They are and How They are Made

What Is a Perfect Hedge?

A perfect hedge is a position by an investor that eliminates the risk of an existing position, or a position that eliminates all market risk from a portfolio. Rarely achieved, a perfect hedge position needs to have a 100% inverse correlation to the initial position.

Understanding a Perfect Hedge

A perfect hedge is often attempted by investors through a combination of options, futures, and other derivatives for defined periods rather than as ongoing protection.

A common example of a near-perfect hedge is when an investor uses a combination of held stock and opposing options positions to insure against any loss in the stock position. The downside of this strategy is that it often limits the gain of the stock position.

Perfect Hedges in a Practical World

A perfect hedge is defined as an ideal hedge based on an investor's risk tolerance. Completely removing all risk from the investment has a similar impact on the potential for rewards. Instead, investors and traders look to establish a range of probability where the worst and best outcomes are both acceptable.

Traders do this by establishing a trading band for the underlying investments in which they are trading. The band can be fixed or can move up and down. However, the more complex the hedging strategy, the more likely it is that the cost to hedge may impact overall profit.

Investors in traditional securities experience see the same results. There are many strategies to hedge an investor's stocks through futures, call and put options, and convertible bonds, but they all incur a cost to implement. Investors try to create hedges through diversification. By finding assets with low correlation or inverse correlation, investors can ensure smoother overall portfolio returns. The cost of hedging is apparent as an investor ties up capital and pays transaction fees throughout the process of diversification.

Popular “Perfect” Hedges

Perfect hedges do exist in theory but are rarely worth the cost for any period except in the most volatile markets. Several types of assets are often referred to as the perfect hedge, a haven for capital in volatile markets. This list includes liquid assets like cash and short-term notes and investments like gold and real estate. These perfect hedges do not experience the volatility of the financial market and illustrate other places in which an investor can shelter cash.

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