What Does Hedging Mean for Investors?
Hedging is a risk management strategy used to protect against potential losses by betting on positions in two opposite directions. As an investment strategy, hedging can be seen as a form of insurance, meaning for a fee, investors can hedge in order to limit the risk of loss in financial markets.
What is Hedging?
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.
Hedging works by holding an investment that will move in the opposite direction of your underlying asset so that if that asset declines, the investment hedge will offset or limit the overall loss.
In practice, hedging occurs in almost every investment portfolio, just sometimes less directly. You could be invested into a fund that utilizes hedging without you having to do any of the work yourself.
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 for coverage.
A reduction in risk means a reduction in potential profits. For the most part, hedging is a technique meant to reduce the risk of loss instead of maximizing potential gains.
How does Hedging Work?
Hedging techniques generally involve the use of financial instruments known as derivatives. Two of the most common derivatives are options and futures. With derivatives, you can develop investment strategies where a loss in one investment is offset by a gain in a derivative.
Typically if the value of your financial product goes down, the value of your hedge goes up, and vice versa.
Options are contracts for the right to buy or sell a stock or other asset at a certain price for a period of time and are often used for hedging strategies.
Individual investors typically hedge for two reasons:
- Over-concentration: An investor owns a lot of stock in one company, so they want to protect against a major drop in that asset.
- Tax Implications: Investors can use hedges to delay the sale of a stock or other asset while protecting its value.
For example, if you own shares of ABC Corp and are looking to protect yourself from short-term losses in ABC’s industry, you can buy a put option on the company. A put option gives you the right to sell ABC at a specific price (called the strike price). This strategy is called a married put. If the stock price of ABC tumbles below the strike price, these losses will be offset by gains in the put option.
To extend on this example, if an investor is worried about a particular input cost of ABC corporation, they can enter into a futures contract or a forward contract. A futures contract is a type of hedging instrument that allows the company to purchase the input good at a specific price at a set date in the future.
What Are the Benefits of Hedging?
- Risk Mitigation: The main benefit of hedging is the ability to manage risk and the investment exposure a portfolio has. Derivatives can be used to protect yourself if assets don’t move the direction you expect.
- Limit Losses: Hedging allows you to help limit your losses. The cost of the hedge will limit your upside, but you can be sure that your losses won’t balloon in the case of a price decline.
- Price Clarity: Companies and even individuals such as farmers use derivatives to eliminate the uncertainty of future commodity prices. By using futures and forward contracts, they can lock in prices for key goods well in advance for their delivery date.
Risks of Hedging
Every hedging strategy has investment risk associated with it. Remember the goal of hedging isn’t to make money but instead just to protect from losses.
The cost of the hedge can’t be avoided, whether it’s the cost of an option or lost profits from being on the wrong side of a futures contract.
Hedging a portfolio isn’t a perfect science. There are many variables that can go wrong. Although risk managers are always shooting for the perfect hedge, this is nearly impossible.
- Limit Gains: While limiting your losses is one of the key benefits of hedging, it will also limit your potential gains. If an investment ends up appreciating and the hedge is unnecessary, you’ll lose the cost of the hedge. Similarly, if a farmer agrees to sell corn at a specific price in the future but the spot market is at even higher prices when the corn is delivered, the farmer will have missed out on those higher profits.
- Costs: Hedging comes with costs, either the direct cost of a derivative contract used to hedge or the cost of lower profits in return for some protection. Be sure to understand all the costs associated with a hedge before moving forward with one.
- Wrong Analysis: It’s possible that the investment that you thought was a great hedge isn’t all that great after all. Imagine owning airline stocks but being concerned that higher fuel costs could impact the company’s profits. You might purchase a basket of energy companies as a hedge, thinking that their higher profits would offset any negative impact felt by the airline industry. A broad economic downturn could send both the price of oil and travel demand plummeting, hurting both industries and making your hedge useless.
Types of Hedging Strategies
Typically investors create hedges using various types of derivatives such as options, futures, and forwards. In certain cases, inverse ETFs may also be an option for hedging but tend to be riskier.
Hedges can come in many forms. You can use derivatives such as options to limit your risk or use less complex assets such as cash. Some investors use short selling to hedge their exposure to certain risks and build their portfolios to profit in the event of a market decline.
Puts give investors the right to sell stock at a predetermined price for a specified time. The investor chooses the price at which the put sells (strike price), providing them with a secure floor for the stock’s price.
Protective puts can limit or eliminate losses but they may come at a cost. Investors must pay a premium to own puts, so they could potentially lose money if the stock never falls low enough to hit the strike price.
Calls give investors the right to buy a stock at a predetermined price for a specified time. If you wanted to hedge your shares of XYZ corp, you could sell covered calls on the stock. The calls would generate income from premiums the buyer pays you as long as the stock doesn’t hit the strike price.
If the stock price falls, the seller of calls can earn premiums. However, if the stock’s price hits the strike price, then your gains are capped at the strike price.
Collars refer to a combination of protective puts and covered calls. An investor buys the puts to protect against a drop in strike price and in theory the calls generate premiums that can be used to pay for puts.
Asset allocation and diversification are used in individual investment strategies to manage risk and returns, but they aren’t themselves hedging strategies. Hedging strategies have a direct negative correlation.
While not perfect hedges, diversification and buying non-correlated assets can work as an indirect hedge for retail investors.
Holding a diversified portfolio may indicate that you don’t know for certain which investments will perform best. You hedge that risk by having exposure to many different areas of the market.
Diversification can hedge against interest rate risk, market volatility, currency risk, or just overall loss of principal by investing in products that benefit from different market conditions.
Hedging for Individuals
For most long-term investors, hedging through options contracts isn’t a strategy usually pursued. If your investment goals are longer-term such as retirement, day-to-day fluctuations in the stock markets shouldn’t worry you.
If the daily volatility doesn’t matter for your portfolio, hedging can end up doing more harm than good. Remember that you’re rewarded in the long term with higher returns for having a higher risk tolerance, and being able to manage short-term volatility.
Diversification can help protect investors against the idiosyncratic risks of individual stocks. While diversification does not guarantee against a loss, it is likely the more effective risk management tool for most retail investors as opposed to hedging.
The Bottom Line
Risk is a given when it comes to investing and it is an essential element of profit-making. Regardless of what kind of investor you are, having a basic knowledge of hedging strategies will lead to better awareness of how investors and companies work to protect themselves.
Whether or not you purchase direct hedges or build a diversified portfolio in order to hedge against potential losses, learning about hedging will help your understanding of financial markets.
This material is provided for informational and educational purposes only. It is not intended to be investment advice and should not be relied on to form the basis of an investment decision