An Introduction to Hedging
Hedge investing is a useful practice that every investor should be aware of. In the stock market, hedging is a way to get portfolio protection—and protection is often just as important as portfolio appreciation.
Even if you are a new investor, it can be beneficial to learn what hedging is and how it works.
Hedging is a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset.
The reduction in risk provided by hedging also typically results in a reduction in potential profits.
Hedging strategies typically involve derivatives, such as options and futures contracts.
What Is Hedging?
The best way to understand hedging is to think of it as a form of insurance. When people decide to hedge, they are insuring themselves against a negative event’s impact on their finances.
This does not prevent every negative event from occurring. However, if a negative event does happen and you’re properly hedged, the impact of the event is reduced.
In practice, hedging occurs almost everywhere. For example, if you buy a homeowner’s insurance, you are hedging yourself against fires, break-ins, or other unforeseen disasters.
Portfolio managers, individual investors, and corporations use hedging techniques to reduce their exposure to various risks.
In financial markets, however, hedging is not as simple as paying an insurance company a fee every year for coverage.
Hedging against investment risk means strategically using financial instruments or market strategies to offset the risk of any adverse price movements. Put another way, investors hedge one investment by making a trade-in another.
For instance, if you are long shares of XYZ corporation, you can buy a put option to protect your investment from large downside moves. However, to purchase an option you have to pay its premium.
A reduction in risk, therefore, always means a reduction in potential profits.
So, hedging, for the most part, is a technique that is meant to reduce a potential loss (and not maximize potential gain).
If the investment you are hedging against makes money, you have also usually reduced your potential profit.
If, however, the investment loses money, and your hedge was successful, you will have reduced your loss.
Hedging techniques generally involve the use of financial instruments known as derivatives. The two most common derivatives are options and futures. With derivatives, you can develop trading strategies where a loss in one investment is offset by a gain in a derivative.
Imagine that you own shares of ABC Corporation. While you believe in the company for the long term, you are concerned about some short-term losses in the industry.
You can purchase a put option on ABC to protect yourself from a fall in the company, which gives you the right to sell ABC at a specific price (also known as the strike price).
If your stock price tumbles below the strike price, these losses will be offset by gains in the put option.
Due to the wide variety of options and futures contracts, an investor can hedge against almost anything, including stocks, commodities, interest rates, and currencies.
Negative aspects of Hedging
Every hedging strategy has a cost associated with it. So, before you decide to use hedging, you should ask yourself if the potential benefits justify the expense.
Hedging isn’t about making money; it’s about protecting against losses.
The cost of the hedge, whether it is the cost of an option–or lost profits from being on the wrong side of a futures contract–can’t be avoided.
What Hedging Means for You
In any case, you should understand how hedges work, even if you never use them. Many big companies and investment funds will hedge in some form.
For example, oil companies might hedge against the price of oil. An international mutual fund might hedge against fluctuations in foreign exchange rates.
Having a basic understanding of hedging can help you comprehend and analyze these investments.
The Bottom Line
Investing involves risk, which is both essential and precarious. No matter what kind of investor you aspire to be, a basic understanding of hedging strategies will help you better understand how companies and investors protect themselves.
It doesn’t matter whether you decide to use derivatives or not, learning how hedging works will help you gain a better understanding of the market, which will always make you a better investor.