Simulate the situation under the circumstances that your speculations are correct (i.e. that your target investment progresses in your favor). Check your total profit under this situation. If the profit is positive, your hedge is valid for this case. For example, if your hedge is to long 20 shares of stock X at $20 per share and short 10 shares of stock Y, which exists within the same industry as stock X, at $40 per share, assume that stock X and stock Y both increase in price (simulating an improvement in the industry). In this case, check your total profit. You will find that it is positive, implying that your hedge is valid in this direction.
Simulate the situation under the circumstances that your speculations are incorrect (i.e. that your target investment does not progress in your favor). Check your total loss in this circumstance and then compare it to your total loss if you had directly invested in your target investment without hedging. If the loss in your hedge is less than the loss without hedging, your hedge is valid. For the previous example, assuming now that the industry’s market deteriorates with stocks in that market falling in price, you will find that you lose money on stock X but gain money on stock Y. Although in total you had negative profit, the gain in stock Y alleviates the loss in stock X, therefore giving a total loss less than the loss you would have suffered had you only invested in stock X. Thus, your hedge is valid in this case.
Run a computer simulation of the derivatives upon which your hedge depends. Check to see at the end of the simulation that the following two facts are confirmed: You profit when your target investment profits and you reduce loss when your target investment loses. Computer software that are capable of running such simulations include R, Maple and Matlab. Use either Markov Chain functions or Brownian Motion functions to simulate the movement of the price of a derivative.