What is a Cross Hedge?

A cross hedge is an investment strategy designed to minimize risk. It usually involves making two investments that appear to contradict each other. Generally, these will be linked so that a factor that affects one investment will likely also affect the other investment to a similar degree, albeit it in the opposite way.

Most uses of a cross hedge involve putting an amount of money into one investment and then a smaller amount into the contrasting investment. The idea is that if one investment goes badly, the other will do well. This limits the profits if the bigger investment goes well, but limits the losses if it goes badly. While it might seem to make more sense to simply put less money into the original investment and not bother with the second investment, using a cross hedge gives the investor more stability and means they aren't in an all-or-nothing situation.

The trickiest element of a cross hedge is choosing two investments with the right relationship. This can be particularly difficult with straightforward stock investments. For example, looking at two companies with a natural rivalry helps to illustrate this situation: if Company A suffered bad publicity and its stock price fell, there is a good chance that Company B would see its business rise, and in turn, its stock price would likely go up. However, it might be the case that Company A's stock price fell because of a reason such as growing concern over the health issues related to that product, in which case Company B's stock price would likely also fall. This would compound the investors losses.

One method some investors use to try to get around this is to use the similarity between stocks to their advantage. Where the two investments are likely to be affected in the same way, the investor can buy one stock in the normal fashion while shorting the other. This means "borrowing" the stock from another trader, selling it now, then buying it back later to return to the trader. If the stock has fallen, the investor will be able to make a profit from the process, athough if it has risen they will lose out.

An example of this in practice would be the stocks of a games console manufacturer and a video game manufacturer. If the console manufacturer's stock falls, it's likely to be down to a lack of sales. In turn, this will likely cause a lack of sales of games and thus cause the game manufacturer's stock to fall.

In practice, most uses of a cross hedge are more complicated. They will often involve not just buying or shorting stocks, but also dealing in futures or options contract, where profitability depends on correctly predicting the relationship between the current price and the market price on a set future date. The principle remains the same though: the second investment should be as likely as possible to prove profitable in the event the first investment goes against the investor.