Diversification And Hedging
The stock price could decline because of decline in revenue, the decline in profits margins, the high cost of financing, high leverage or misconduct of the management. All this could cause the stock prices to decline. Learn more about it here.
You can diversify this unsystematic risk by not investing a lot of your money into one single company. You could diversify your money by investing in many companies at a time. So in case one of the companies to perform well and fall in price then the other companies will not be affected, even if the stocks are of the same sector. The higher is the number of stock varieties in your portfolio the higher is the diversification for unsystematic risks.
You should consider having at least 21 stocks in the portfolio to get the required amount of diversification. If you have more than this then it may not necessarily be beneficial for you.
Even after you diversify your portfolio the systematic risk will affect the stocks in the market and even if you diversify your portfolio you cannot do much about protecting your portfolio from the systematic risks. Whatever you do the stock prices will fall in value.
Systematic risks are a part of the system and you cannot diversify it. But you can hedge it. So it is important to understand that by hedging we do not mean diversification.
How to hedge a single stock
Suppose you just have a single stock in your portfolio. Then how do you hedge that? You buy a single stock and this means that your directional analysis on this stock is long. You now realize that the quarterly results will come out and you think that it could very well happen that the stock prices could fall down. To prevent the loss that you foresee you decide to hedge your position.
When you plan to hedge the long position you buy a counter position in the same stock. So you enter into a short future position of the same stock for the same lot size.
So, basically, what are you doing here? You buy the stocks on the spot market and at the same time short in the future market. The number of stocks in the spot market should equal to the lot size of the futures market
This is the way you hedge your position in the spot equity market.