Micro-Hedge

What Is a Micro-Hedge?

A micro-hedge is an investment technique used to eliminate the risk of a single asset from a larger portfolio. In most cases, a micro-hedge involves taking an offsetting position in that single asset. Offsetting positions can include taking short positions in similar shares, or options or futures contracts of that same asset.

Understanding Micro-Hedging

A micro-hedge can reduce or eliminate the risk of one asset in a portfolio, but it will have little effect on the risk or the overall portfolio, unless the portfolio is highly concentrated. If this asset is part of a larger portfolio, the hedge will eliminate the risk of the one asset but will have less of an effect on the risk associated with the portfolio.

All investments are accompanied by various levels of risk. Investors create well-diversified portfolios of securities to effectively manage those risks. However, there are times when a single security within a portfolio can cause great concern. It could be because the security is a stock that is extremely costly, or because it is a security with a history of volatility. Whatever the case, a micro-hedge can be an effective way to deal with these securities.

Example of a Micro-Hedge

Say you are holding the stock of a company and want to eliminate the price risks associated with that stock. To offset your position in the company, you could take a short position by purchasing a put option on that single stock, thereby establishing a floor price for the period of the options contract. This strategy is used when an investor feels very uncertain about the future movement of a single asset.

A micro-hedge can also be created by purchasing additional securities that should move in opposite directions under the same conditions; for instance, a corporate bond against a share of stock in the same company. One problem, however, is that it is difficult to predict which direction securities will move under what conditions, and historical correlations are not necessarily a good indicator of future outcomes.

Micro-Hedges vs. Macro-Hedges

Micro-hedges can be contrasted with macro-hedges. A macro-hedge is an investment technique used to mitigate or eliminate downside systemic risk from a portfolio of assets. Macro-hedging strategies typically involve using derivatives to take short positions on broad market catalysts that can negatively affect the performance of a portfolio or a specific underlying asset.

The "macro" in macro-hedge refers to risk mitigation around macroeconomic events. Therefore, macro-hedging generally requires significant foresight, extensive access to economic data, and superior forecasting skills to project the expected reaction of markets and investment securities when trends occur. However, in some cases, macro-hedging positions may be easily foreseen by a series of events leading to a predetermined outcome.