Key points
- Common hedges: put options (downside protection), short sales (directional offset), futures (duration protection).
- Perfect hedge (1.0 ratio) eliminates risk but costs premiums.
- Rebalancing hedges becomes crucial during volatility.
Example
An investor holding shares can buy put options that pay out if the index falls below a set level. The cost of the options is the price of that insurance, and it rises when markets are nervous.
In history
Demand for protection jumped after the 1987 crash and has kept index put options relatively expensive ever since, especially those that pay out in a large fall.
Related terms