Hedging Bets Levels the Ride but Cuts Profit Potential

Nobody really wants to buy automobile, home, health, or other insurance. These hedges against risk are expensive. But their price is low relative to the perils they cover. Finding the cash to pay the premiums is one thing, paying the costs associated with car crashes, house fires, and hospitalization is another.

Conversely, investors like to hedge against risk. For instance, money managers consider it prudent to buy "puts," options which yield leveraged profits when stock prices fall, to protect their portfolios. In strong markets, they let the options lapse - absorbing the costs in the rising value of their shares. In weak markets, they exercise the options - using proceeds to compensate for falling stock prices.

Casinos, which more closely resemble financial exchanges than the barons of the bourse generally admit, likewise offer opportunities to hedge. Craps, in particular, is a virtual candy store for kids whose kicks come from cleverly covering their assets.

As an example, say a craps player bets on the pass line. On the initial or "come-out" roll, seven or 11 wins even money then and there; two, three, or 12 - a "craps" - loses on the spot. Other results don't yield instant decisions, but establish the "points" for subsequent rolls; these win if repeated and lose on sevens.

Many players hedge pass line bets with money on "any craps." A dollar on this "proposition" pays $7 for a two, three, or 12 - the very rolls which send pass line bets south on the come-out; with all other results, any craps is an instant loser.

Here's what can happen on the come-out with a $5 line bet and $1 any craps. The dice show seven or 11: the bettor wins $5 on the line, loses $1 on any craps, and is happy with $4 net profit. The dice show two, three, or 12: the bettor loses $5 on the line, wins $7 on any craps, and is pleased because the side bet brought $2 net gain. The dice show anything else: the $5 becomes a bet on the point, the $1 is lost, but the player thinks the hedge was well spent because most of the initial outlay is still in action.

Is this strategy as sound as it seems? Or, is it too clever by a half? No one bonnet fits all babies. But you can make your own best decision by considering the house edge and fluctuation associated with straight pass line bets and hedges on any craps.

Assume $6 total at risk. With it all on the line, "cost" of the edge is $0.085 and fluctuation is just under $6 per bet. For $5 on the pass line and $1 any craps, cost of the edge more than doubles - to $0.182, but fluctuation drops to $4.75.

The increased house edge imposed by hedging erodes players' expected profits. Over the short term, the bite doesn't amount to much; over the long term, it can become significant. The decreased volatility achieved by hedging smooths the bumps in the game. This helps players with small bankrolls who might be knocked out by normal downswings; it hinders those with enough time and money to outride characteristic cold periods.

The effect in the stock market is similar. Although most investment professionals hedge, a feature in the April 27 Wall Street Journal attributes this partly to a contemporary business climate emphasizing short-term performance. The article questioned conventional wisdom, which advocates hedging major long-term investments, because stock price fluctuations have only brief effects. "Volatility does not equal risk," one money manager explained. His own experience showed that without hedging, his firm's investment results would have been more volatile but much stronger. This particular firm realized an impressive annual average return of 13.7 percent over the past five years, but would have achieved an astounding 16.6 percent had they not hedged.

Sumner A Ingmark, immortal muse of the casino scene, put this perspective on hedging:

For bettors lacking in endurance,
Judicious hedging's good insurance.
But long-term players, flush and eager,
Find hedging keeps their profits meager.