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Hedging

Taking an offsetting position to reduce an exposure. Every hedge costs something, and the cost is frequently less visible than the risk it removes.

MadStockAlerts Research · Updated September 23, 2026

What to Take Away

A hedge reduces an exposure and does not remove risk.
Basis risk is what remains when the hedge is not the same instrument.
Every hedge has a cost, whether a premium, a spread or foregone upside.
A partial hedge is a decision about how much exposure to keep.
The simplest hedge is holding less, and it has no basis risk.

MAD Academy Training Video · 0:45

Paying to Remove a Risk

A hedge exchanges an uncertain outcome for a smaller certain cost, which means a hedge that never pays out did its job.

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The instruments

Approach	Cost	What remains
Reduce the position	None. Foregone participation	No basis risk at all
Buy a put	The premium, recurring	Basis risk is minimal on the same security
Sell an index future	Margin, and basis risk	The difference between the position and the index
Short a related security	Borrow cost and basis risk	Whatever separates the two companies
A collar	Foregone upside	Same as the put, with a cap added

The first row deserves more attention than it gets. Reducing a position achieves a proportional reduction in exposure with no premium, no expiry, no basis risk and no additional complexity.

Basis risk

A hedge using a different instrument from the exposure leaves the difference between them unhedged. Shorting an index against a single stock removes the market exposure and leaves everything specific to the company, which is frequently what was being worried about.

The hedge worked and the position still lost

Scroll the chart sideways to see all of it.

The holding
The index short
Net

An index hedge removes the market component. What remains is the company-specific move, which in this case was the entire problem. Schematic.

The costs that are not premiums

Foregone upside, which a collar or a short pays with rather than with cash.
Margin and financing on a futures or short leg.
Transaction costs on both establishing and removing the hedge.
Complexity, which is a real cost in decisions that have to be made quickly.
Tax consequences, since some hedging structures affect holding periods.

The last item is specific and easy to miss. Certain offsetting positions can suspend a holding period under the constructive sale and straddle rules, which is a mechanical consequence rather than a matter of intent. This is a description of the rules and not tax advice.

When a hedge is the wrong answer

A position that is too large to hold comfortably is a sizing problem, and hedging it converts a simple decision into a complex one with new risks attached. The question worth asking first is whether the exposure would be taken at all today, at this size.

Deciding the hedge ratio

A hedge is rarely one-for-one. How much of an offsetting instrument to hold depends on how sensitively it moves against the exposure being hedged.

hedge ratio ≈ position value x beta to the hedging instrument

beta is estimated from historical returns, with all the caveats that carries
a high-beta position requires more of an index hedge than its dollar value suggests

The estimate carries the same instability the beta article describes. A hedge ratio computed from a calm period is wrong in a crisis, and the crisis is when the hedge is being relied upon.

That instability is a strong argument for the simplest available approach. Reducing the position by a chosen fraction achieves a known reduction in exposure with no estimate involved, which is why the first row of the instruments table is there.

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Educational content only. MadStockAlerts provides market commentary, research, and educational content. It is not personalized investment advice, and nothing here is a recommendation to buy or sell any security. Trading and investing involve substantial risk, including loss of capital. See the Risk Disclosure and Customer Agreement.

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