Hedging a stock price
A stock trader believes that the stock price of Company A will rise over the next month, due to the company's new and efficient method of producing widgets. He wants to buy Company A shares to profit from their expected price increase. But Company A is part of the highly volatile widget industry. If the trader simply bought the shares based on his belief that the Company A shares were underpriced, the trade would be a speculation.
A stock trader believes that the stock price of Company A will rise over the next month, due to the company's new and efficient method of producing widgets. He wants to buy Company A shares to profit from their expected price increase. But Company A is part of the highly volatile widget industry. If the trader simply bought the shares based on his belief that the Company A shares were underpriced, the trade would be a speculation.
Since the trader is interested in the company, rather than the industry, he wants to hedge out the industry risk by short selling an equal value (number of shares × price) of the shares of Company A's direct competitor, Company B. If the trader was able to short sell an asset whose price had a mathematically defined relation with Company A's stock price (for example a call option on Company A shares) the trade might be essentially riskless. But in this case, the risk is lessened but not removed.
The first day the trader's portfolio is:
Long 1000 shares of Company A at Rs.1 each
Short 500 shares of Company B at Rs.2 each
(Notice that the trader has sold short the same value of shares.)
On the second day, a favorable news story about the widgets industry is published and the value of all widgets stock goes up. Company A, however, because it is a stronger company, goes up by 10%, while Company B goes up by just 5%:
Long 1000 shares of Company A at Rs.1.10 each: Rs.100 gain
Short 500 shares of Company B at Rs.2.10 each: Rs.50 loss
(In a short position, the investor loses money when the price goes up.)
The trader might regret the hedge on day two, since it reduced the profits on the Company A position. But on the third day, an unfavorable news story is published about the health effects of widgets, and all widgets stocks crash: 50% is wiped off the value of the widgets industry in the course of a few hours. Nevertheless, since Company A is the better company, it suffers less than Company B:
Value of long position (Company A):
Day 1: Rs.1000
Day 2: Rs.1100
Day 3: Rs.550 => (Rs.1000 – Rs.550) = Rs.450 loss
Value of short position (Company B):
Day 1: -Rs.1000
Day 2: -Rs.1050
Day 3: -Rs.525 => (Rs.1000 – Rs.525) = Rs.475 profit
Without the hedge, the trader would have to lost Rs.450 (or Rs.900 if the trader took the Rs.1000 he has used in short selling Company B's shares to buy Company A's shares as well). But the hedge - the short sale of Company B - gives a profit of Rs.475, for a net profit of Rs.25 during a dramatic market collapse.
source wiki
Hedging can be done effectively using a single company shares and its call or put option on different rates.
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