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What is a Hedge
A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security.
BREAKING DOWN Hedge
Hedging is analogous to taking out an insurance policy. If you own a home in a flood-prone area, you will want to protect that asset from the risk of flooding – to hedge it, in other words – by taking out flood insurance. In this example, you cannot prevent a flood, but you can work ahead of time to mitigate the dangers if and when a flood occurs. There is a risk-reward tradeoff inherent in hedging; while it reduces potential risk, it also chips away at potential gains. Put simply, hedging isn’t free. In the case of the flood insurance policy example, the monthly payments add up, and if the flood never comes, the policy holder receives no payout. Still, most people would choose to take that predictable, circumscribed loss rather than suddenly lose the roof over their head.
In the investment world, hedging works in the same way. Investors and money managers use hedging practices to reduce and control their exposure to risks. In order to appropriately hedge in the investment world, one must use various instruments in a strategic fashion to offset the risk of adverse price movements in the market. The best way to do this is to make another investment in a targeted and controlled way. Of course, the parallels with the insurance example above are limited: in the case of flood insurance, the policy holder would be completely compensated for her loss, perhaps less a deductible. In the investment space, hedging is both more complex and an imperfect science.
A perfect hedge is one that eliminates all risk in a position or portfolio. In other words, the hedge is 100% inversely correlated to the vulnerable asset. This is more an ideal than a reality on the ground, and even the hypothetical perfect hedge is not without cost. Basis risk refers to the risk that an asset and a hedge will not move in opposite directions as expected; „basis“ refers to the discrepancy.
How Does Hedging Work?
The most common way of hedging in the investment world is through derivatives. Derivatives are securities that move in correspondence to one or more underlying assets. They include options, swaps, futures and forward contracts. The underlying assets can be stocks, bonds, commodities, currencies, indices or interest rates. Derivatives can be effective hedges against their underlying assets, since the relationship between the two is more or less clearly defined. It’s possible to use derivatives to set up a trading strategy in which a loss for one investment is mitigated or offset by a gain in a comparable derivative.
For example, if Morty buys 100 shares of Stock plc (STOCK) at $10 per share, he might hedge his investment by taking out a $5 American put option with a strike price of $8 expiring in one year. This option gives Morty the right to sell 100 shares of STOCK for $8 any time in the next year. If one year later STOCK is trading at $12, Morty will not exercise the option and will be out $5. He’s unlikely to fret, though, since his unrealized gain is $200 ($195 including the price of the put). If STOCK is trading at $0, on the other hand, Morty will exercise the option and sell his shares for $8, for a loss of $200 ($205 including the price of the put). Without the option, he stood to lose his entire investment.
The effectiveness of a derivative hedge is expressed in terms of delta, sometimes called the „hedge ratio.“ Delta is the amount the price of a derivative moves per $1 movement in the price of the underlying asset.
Fortunately, the various kinds of options and futures contracts allow investors to hedge against most any investment, including those involving stocks, interest rates, currencies, commodities, and more.
The specific hedging strategy, as well as the pricing of hedging instruments, is likely to depend upon the downside risk of the underlying security against which the investor would like to hedge. Generally, the greater the downside risk, the greater the hedge. Downside risk tends to increase with higher levels of volatility and over time; an option which expires after a longer period and which is linked to a more volatile security will thus be more expensive as a means of hedging. In the STOCK example above, the higher the strike price, the more expensive the option will be, but the more price protection it will offer as well. These variables can be adjusted to create a less expensive option which offers less protection, or a more expensive one which provides greater protection. Still, at a certain point, it becomes inadvisable to purchase additional price protection from the perspective of cost effectiveness.
Hedging Through Diversification
Using derivatives to hedge an investment enables for precise calculations of risk, but requires a measure of sophistication and often quite a bit of capital. Derivatives are not the only way to hedge, however. Strategically diversifying a portfolio to reduce certain risks can also be considered a hedge, albeit a somewhat crude one. For example, Rachel might invest in a luxury goods company with rising margins. She might worry, though, that a recession could wipe out the market for conspicuous consumption. One way to combat that would be to buy tobacco stocks or utilities, which tend to weather recessions well and pay hefty dividends.
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This strategy has its tradeoffs: If wages are high and jobs are plentiful, the luxury goods maker might thrive, but few investors would be attracted to boring counter-cyclical stocks, which might fall as capital flows to more exciting places. It also has its risks: There is no guarantee that the luxury goods stock and the hedge will move in opposite directions. They could both drop due to one catastrophic event, as happened during the financial crisis, or for unrelated reasons, such as floods in China which drive tobacco prices up, while a strike in Mexico does the same to silver.
In the index space, moderate price declines are quite common, and they are also highly unpredictable. Investors focusing in this area may be more concerned with moderate declines than with more severe ones. In these cases, a bear put spread is a common hedging strategy.
In this type of spread, the index investor buys a put which has a higher strike price. Next, he sells a put with a lower price but the same expiration date. Depending upon the way that the index behaves, the investor thus has a degree of price protection equal to the difference between the two strike prices. While this is likely to be a moderate amount of protection, it is often sufficient to cover a brief downturn in the index.
Risks of Hedging
Hedging is a technique utilized to reduce risk, but it’s important to keep in mind that nearly every hedging practice will have its own downsides. First, as indicated above, hedging is imperfect and is not a guarantee of future success, nor does it ensure that any losses will be mitigated. Rather, investors should think of hedging in terms of pros and cons. Do the benefits of a particular strategy outweigh the added expense it requires? Because hedging will rarely if ever result in an investor making money, it’s worth remembering that a successful hedge is one that only prevents losses.
Hedging and the Everyday Investor
For most investors, hedging will never come into play in their financial activities. Many investors are unlikely to trade a derivative contract at any point. Part of the reason for this is that investors with a long-term strategy, such as those individuals saving for retirement, tend to ignore the day-to-day fluctuations of a given security. In these cases, short-term fluctuations are not critical because an investment will likely grow with the overall market.
For investors who fall into the buy-and-hold category, there may seem to be little to no reason to learn about hedging at all. Still, because large companies and investment funds tend to engage in hedging practices on a regular basis, and because these investors might follow or even be involved with these larger financial entities, it’s useful to have an understanding of what hedging entails so as to better be able to track and comprehend the actions of these larger players.
Hedging is an investment technique designed to offset a potential loss on one investment by purchasing a second investment that you expect to perform in the opposite way.
For example, you might sell short one stock, expecting its price to drop. At the same time, you might buy a call option on the same stock as insurance against a large increase in value.
exposure to price fluctuations. See EXCHANGE RATE EXPOSURE.
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A Beginner’s Guide to Hedging
Although it might sound like something done by your gardening-obsessed neighbor, hedging is a useful practice that every investor should know about. In the markets, hedging is a way to get portfolio protection—and protection is often just as important as portfolio appreciation.
Hedging, however, is often discussed broadly more often than it is explained, making it seem as though it belongs only to the most esoteric financial realms. Even if you are a beginning investor, you can learn what hedging is, how it works, and what techniques investors and companies use to protect themselves.
- Hedging is a risk management strategy employed to offset losses in investments.
- The reduction in risk typically results in a reduction in potential profits.
- Hedging strategies typically involve derivatives, such as options and futures.
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 to their finances. This doesn’t prevent all negative events from happening, but something does happen and you’re properly hedged, the impact of the event is reduced.
In practice, hedging occurs almost everywhere, and we see it every day. For example, if you buy 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.
Technically, to hedge you would trade make offsetting trades in securities with negative correlations. Of course, nothing in this world is free, so you still have to pay for this type of insurance in one form or another.
For instance, if you are long shares of XYZ corporation, you can buy a put option to protect you from large downside moves—but the option will cost you since you have to pay its premium.
A reduction in risk, therefore, will always mean a reduction in potential profits. So, hedging, for the most part, is a technique not by which you will make money but by which you can reduce potential loss. If the investment you are hedging against makes money, you have typically reduced your potential profit, but if the investment loses money, your hedge, if successful, reduces that loss.
A Beginner’s Guide To Hedging
Hedging techniques generally involve the use of financial instruments known as derivatives, the two most common of which are options and futures. Keep in mind that with these instruments, you can develop trading strategies where a loss in one investment is offset by a gain in a derivative.
Say you own shares of Cory’s Tequila Corporation (ticker: CTC). Although you believe in this company for the long run, you are a little worried about some short-term losses in the tequila industry. To protect yourself from a fall in CTC, you can buy a put option (a derivative) on the company, which gives you the right to sell CTC at a specific price (strike price). This strategy is known as a married put. If your stock price tumbles below the strike price, these losses will be offset by gains in the put option.
The other classic hedging example involves a company that depends on a certain commodity. Let’s say Cory’s Tequila Corporation is worried about the volatility in the price of agave, the plant used to make tequila. The company would be in deep trouble if the price of agave were to skyrocket, which would severely eat into their profits.
To protect (hedge) against the uncertainty of agave prices, CTC can enter into a futures contract (or its less-regulated cousin, the forward contract), which allows the company to buy the agave at a specific price at a set date in the future. Now, CTC can budget without worrying about the fluctuating commodity.
If the agave skyrockets above the price specified by the futures contract, the hedge will have paid off because CTC will save money by paying the lower price. However, if the price goes down, CTC is still obligated to pay the price in the contract and would have been better off not hedging.
Because there are so many different types of options and futures contracts, an investor can hedge against nearly anything, including a stock, commodity price, interest rate, or currency. Investors can even hedge against the weather.
Hedging is not the same as speculating, which involves assuming more investment risks to earn profits.
Disadvantages of Hedging
Every hedge has a cost; so before you decide to use hedging, you must ask yourself if the benefits received from it justify the expense. Remember, the goal of hedging isn’t to make money but to protect from 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, cannot be avoided. This is the price you pay to avoid uncertainty.
While it’s tempting to compare hedging to insurance, insurance is far more precise. With insurance, you are completely compensated for your loss (usually minus a deductible). Hedging a portfolio isn’t a perfect science and things can go wrong. Although risk managers are always aiming for the perfect hedge, it is difficult to achieve in practice.
What Hedging Means for You
The majority of investors will never trade a derivative contract. In fact, most buy-and-hold investors ignore short-term fluctuation altogether. For these investors, there is little point in engaging in hedging because they let their investments grow with the overall market. So why learn about hedging?
Even if you never hedge for your own portfolio, you should understand how it works, because many big companies and investment funds will hedge in some form. Oil companies, for example, might hedge against the price of oil, while an international mutual fund might hedge against fluctuations in foreign exchange rates. An understanding of hedging will help you to comprehend and analyze these investments.
The Bottom Line
Risk is an essential yet precarious element of investing. Regardless of what kind of investor one aims to be, 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 decide to start practicing the intricate uses of derivatives, learning about how hedging works will help advance your understanding of the market, which will always help you be a better investor.
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