Hedging is an insurance

We've heard numerous cases that derivatives causes disastrous results: Baring's failure, Orange County's bankruptcy, CITIC Pacific currency loss, etc. Buffet called derivatives "massive destruction weapon". Is derivative evil? We use derivative as a hedge vehicle and it is a powerful tool if it is well understood.

Hedging philosophy is, in a rarely expressed way, equivalent to insurance, in which risk is shared by other parties. Many investors either don't hedge or don't know how hedging works or find more efficient hedging vehicles.

In a simple way, when an asset holder long a position, let's call the position the underlying, the holder would automatically give expectation that the underlying would go up. However, what if the expectation is wrong? The most obvious way is to short a mirror or hedge to the underlying. The mirror can be all sorts of derivatives: futures, swaps, options, etc. Then, the long and short move in the same velocity and opposite direction so that they can cancel out each other. Apparently, hedging cost will incur along the thinking. In other words, there will be no profit and loss (P&L) out of the underlying and the hedging. That is not the purpose of the trade, which intended to make profit.

Nothing went wrong in this senario. In short, we share our expectation (price goes up in the above case) with others who bet price would drop. Same as the underlying, there must be someone out there wants to take the other side risk. When price does go up, the holder was right and can unwind the hedging position by either cancel it and extend it to a higher price level. On the contrary, if price drops, he can do similar things to exit all position such that the hedging gain can offset the underlying loss.

Obviously, no one gained anything from the underlying except the holder himself lost over his expectation but someone on the hedging side did take losss. This is an important point: the underlying may or may not take loss depending on what vehicle is used but the hedging for sure has winner and loser. Thus, we can image hedging as an insurance shared by the two participants.

We would like to reduce hedging cost as much as possible. This can be done when the hedging has leverage power. That is, $1 hedge can cover $10, for example, the underlying. That is why most derivatives provide margin power. Otherwise, they would be less attractive.