Everybody buys stocks, and hope the price goes up in the future. Or some of us even bet short hoping the price falls. However this action with stocks is quite similar to being naked from the eye of hedging.
Say you invest $100, if tomorrow the price goes up. You are happy. But in a worst case, the price halves, you lose half. Blood for blood, crude and simple.
The price will go up
Have you heard “the price will go up”. Oh yeah, I hear this line almost everyday, including myself. But this is not the point, the point is that the action itself is naked. Because if the price doesn’t go up, there’s not much you can do. The loss is a loss, no matter what unit you are using to measure it. And worst of all, no one can help you when that happens, not a single person.
I can limit my loss
Some of us add a protection for their trades, such as setting up a limit. If the value lose 3%, we then fold and quit this game so that the loss can be only as high as 3%. Say 3% is the accurate number, most of time it’s far from the truth. But even 3% is the truth, 3% is still a loss. Suppose your betting ratio is 50/50, 50 being successful. The chance to win is merely 50%, while the worst case still lands you a 3% loss. And when it happens, you can fold only. Once again, no one can help you when that happens, except you are grateful that you only lose 3% of what you had.
I have an insurance
Wow, so buying a stock is a naked game? Unfortunately, yes. But I thought some pros buy insurance for this type of thing. Interestingly you mention that, however, hedging is only valid when you first receive a meaningful gain at the beginning of the deal. I bet no one told you that before.
For instance, you own a car, you use your car for work, this is a gain you have already established; now in order for you to cover your potential loss, you purchase an insurance.
An insurance has to have a payout large enough to make sense. Say you pay $50 a month for the insurance, when you run into an accident, the insurance pays you $20k if the car is totaled. This seems to be a bargain. If the monthly payment was as big as the car value, nobody would buy the insurance.
Last but not least, insurance is to cover your loss with the goal to keep the value intact. Even after the accident, you can still own a car with a similar value. But it shouldn’t give you extra gain on paper. The insurance won’t give you a sport car for your Toyota in any situation. Because hedging isn’t speculation, that’s why trading is normally termed as speculation in the basic level.
Conclusion
I hope now you see purchasing a stock isn’t as naive as it sounds. Because down to the bottom, it is a naked game. The nature of it is quite similar to the gamble at casino where we know we absolutely will lose eventually.
In order to play the game right, if there’s any a better way, we need to look for some type of insurance that isn’t intrinsically embedded in the stock value itself.
