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, as he believes that shares are currently underpriced. But Company A is part of a highly volatile widget industry. So there is a risk of a future event that affects stock prices across the whole industry, including the Company A along all other companies. Since the trader is interested in the specific company, rather than the entire industry, he wants to hedge out the industry-related risk by short selling an equal value of the shares of Company A's direct competitor, Company B. The first day the trader's portfolio is:

Long 1,000 shares of Company A at $1 each Short 500 shares of Company B at $2 each

The trader has sold short the same value of shares (the value, number of shares price, is $1000 in both cases). 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 put option on Company A shares), the trade might be essentially riskless. In this case, the risk would be limited to the put option's premium. 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, increases by 10%, while Company B increases by just 5%:

Long 1,000 shares of Company A at $1.10 each: $100 gain Short 500 shares of Company B at $2.10 each: $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: $1,000 Day 2: $1,100 Day 3: $550 => ($1,000 $550) = $450 loss

Value of short position (Company B):

Day 1: $1,000 Day 2: $1,050 Day 3: $525 => ($1,000 $525) = $475 profit

Without the hedge, the trader would have lost $450 (or $900 if the trader took the $1,000 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 $475, for a net profit of $25 during a dramatic market collapse.