It is well known that hedging is crucial for preventing sharp trading losses.
Note the following example. A trader takes a position in Ford. Shares are up $0.10 (0.5 percent) while the market is flat; the trade looks like it will be successful. However, Russia announces it will begin military activity on the Ukrainian border and the broad market begins to sharply sell off.
What was a profitable trade is now in the red. That does not mean the pick was necessarily bad. With hedged trades, the key is to focus on benchmark returns.
If the trader chooses wrong, the hedge will limit losses in the same way that it limits gains.
The advantage of choosing two very similar securities is that market movement or fundamental data that would affect a select group of stocks significantly more than others is accounted for. A drawback of this approach is that a news item that affects the hedge specifically can result in grossly unexpected gains or losses.
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