What Is a Micro-Hedge?
A micro-hedge is a technique which allows investors to offset the risk of one particular security that they are currently holding. This is the opposite of a macro-hedge, which occurs when an investor attempts to hedge the risk associated with his or her entire portfolio. Using a micro-hedge mitigates the damage that can be done by the failure of one security, such as a single stock. Some of the strategies for micro-hedging include using derivative contracts intended to sell the security in question or buying another security that performs in an inverse relationship to the security being hedged.
All investments are accompanied by various levels of risk. When an investor comprises a well-diversified portfolio of securities, those risks can be effectively managed. There are certain times when a single security within a portfolio can be the cause of great concern. It could be because the security is a stock that is extremely costly, or because it's a security with a history of volatility. Whatever the case, a micro-hedge can be an effective way to deal with these securities.
It is important to understand that a micro-hedge is intended to mitigate the risk involved with just one security. As such, the technique cannot protect an entire portfolio. Instead, it can be used to keep a single stock or other security from causing too much of a negative impact. Micro-hedging is necessary if the investor insists on holding on to the potentially problematic stock, perhaps because of its potential or because of dividend rights or other benefits the investor possesses.
Derivatives are one way to offset risk with a micro-hedge. These contracts, which allow investors to speculate on prices of securities without actually paying the full price of buying them, can be set against the security that is the target of the hedge. For example, an option contract giving an investor the chance to sell a particular stock if it reaches a certain price can be used to protect an investor if he or she holds that stock and is fearful of a drop in price.
Another way to micro-hedge is by finding securities that work in inverse proportion to one another. This means that, as one security rises in price, another tends to drop in price. As an example, if an investor holds Stock A, and Stock B tends to move in inverse proportion to Stock A, buying Stock B is a good way to hedge Stock A. The only problem with this strategy is that it is rare that an inverse relationship can be found which can be trusted with absolute certainty.
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