Hedging Explained

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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 talked about broadly more than it is explained, making it seem as though it belongs only to the most esoteric financial realms. Even if you are a beginner, you can learn what hedging is, how it works, and what techniques investors and companies use to protect themselves.

Key Takeaways

  • 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 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 off-setting 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 will have typically reduced the profit you could have made, but if the investment loses money, your hedge, if successful, will reduce that loss.

A Beginner’s Guide To Hedging

Understanding Hedging

Hedging techniques generally involve the use of financial instruments known as derivatives, the two most common of which are options and futures. We’re not going to get into the nitty-gritty of describing how these instruments work. Just 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.

Let’s see how this works with an example. 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.

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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.

We’ve been comparing hedging to insurance, but we should emphasize 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 to You

The majority of investors will never trade a derivative contract in their life. 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.

Hedging basics: What is a hedge?

Hedging is often considered an advanced investing strategy, but the principles of hedging are fairly simple. With the popularity – and accompanying criticism – of hedge funds, the practice of hedging became more widespread. Despite this, it is still not widely understood.

Everyday Hedges

Most people have, whether they know it or not, engaged in hedging. For example, when you buy life insurance to support your family in the case of your death, this is a hedge. You pay money in monthly sums for the coverage provided by an insurance company. Although the textbook definition of hedging is an investment taken out to limit the risk of another investment, insurance is an example of a real-world hedge.

[When trading options, investors leverage puts as an insurance policy to protect themselves from losses if the instrument they purchased decreases in value. To learn how successful traders use options to curb risk and increase earnings, as well as other basic options trading strategies, check out Investopedia Academy’s Options for Beginners course.]

How Are Futures Used To Hedge A Position?

Hedging by the Book

Hedging, in the Wall Street sense of the word, is best illustrated by example. Imagine that you want to invest in the budding industry of bungee cord manufacturing. You know of a company called Plummet that is revolutionizing the materials and designs to make cords that are twice as good as its nearest competitor, Drop, so you think that Plummet’s share value will rise over the next month.

Unfortunately, the bungee cord manufacturing industry is always susceptible to sudden changes in regulations and safety standards, meaning it is quite volatile. This is called industry risk. Despite this, you believe in this company; you just want to find a way to reduce the industry risk. In this case, you are going to hedge by going long on Plummet while shorting its competitor, Drop. The value of the shares involved will be $1,000 for each company.

If the industry as a whole goes up, you make a profit on Plummet but lose on Drop – hopefully for a modest overall gain. If the industry takes a hit, for example if someone dies bungee jumping, you lose money on Plummet but make money on Drop.

Basically, your overall profit – the profit from going long on Plummet – is minimized in favor of less industry risk. This is sometimes called a pairs trade, and it helps investors gain a foothold in volatile industries or find companies in sectors that have some kind of systematic risk.

Expansion

Hedging has grown to encompass all areas of finance and business. For example, a corporation may choose to build a factory in another country that it exports its product to in order to hedge against currency risk. An investor can hedge their long position with put options, or a short seller can hedge a position though call options. Futures contracts and other derivatives can be hedged with synthetic instruments.

Basically, every investment has some form of a hedge. Besides protecting an investor from various types of risk, it is believed that hedging makes the market run more efficiently.

One clear example of this is when an investor purchases put options on a stock to minimize downside risk. Suppose that an investor has 100 shares in a company and that the company’s stock has made a strong move from $25 to $50 over the past year. The investor still likes the stock and its prospects looking forward but is concerned about the correction that could accompany such a strong move.

Instead of selling the shares, the investor can buy a single put option, which gives them the right to sell 100 shares of the company at the exercise price before the expiry date. If the investor buys the put option with an exercise price of $50 and an expiry day three months in the future, they will be able to guarantee a sale price of $50 no matter what happens to the stock over the next three months. The investor simply pays the option premium, which essentially provides some insurance from downside risk.

The Bottom Line

Hedging is often unfairly confused with hedge funds. Hedging, whether in your portfolio, your business or anywhere else, is about decreasing or transferring risk. Hedging is a valid strategy that can help protect your portfolio, home and business from uncertainty.

As with any risk/reward tradeoff, hedging results in lower returns than if you “bet the farm” on a volatile investment, but it also lowers the risk of losing your shirt. Many hedge funds, by contrast, take on the risk that people want to transfer away. By taking on this additional risk, they hope to benefit from the accompanying rewards.

Hedging and How It Works With Examples

Protect yourself from financial crises

Image by Yifan Wu © The Balance 2020

A hedge is an investment that protects your finances from a risky situation. Hedging is done to minimize or offset the chance that your assets will lose value. It also limits your loss to a known amount if the asset does lose value. It’s similar to home insurance. You pay a fixed amount each month. If a fire wipes out all the value of your home, your loss is the only the known amount of the deductible. 

Hedging Strategies

Most investors who hedge use derivatives. These are financial contracts that derive their value from an underlying real asset, such as a stock.   An option is the most commonly used derivative. It gives you the right to buy or sell a stock at a specified price within a window of time.

Here’s how it works to protect you from risk. Let’s say you bought stock. You thought the price would go up but wanted to protect against the loss if the price plummets. You’d hedge that risk with a put option. For a small fee, you’d buy the right to sell the stock at the same price. If it falls, you exercise your put and make back the money you just invested minus the fee. 

Diversification is another hedging strategy. You own an assortment of assets that don’t rise and fall together. If one asset collapses, you don’t lose everything.   For example, most people own bonds to offset the risk of stock ownership. When stock prices fall, bond values increase. That only applies to high-grade corporate bonds or U.S. Treasurys. The value of junk bonds falls when stock prices do because both are risky investments.

Hedges and Hedge Funds

Hedge funds use a lot of derivatives to hedge investments. These are usually privately-owned investment funds. The government doesn’t regulate them as much as mutual funds whose owners are public corporations. 

Hedge funds pay their managers a percent of the returns they earn. They receive nothing if their investments lose money. That attracts many investors who are frustrated by paying mutual fund fees regardless of its performance.

Thanks to this compensation structure, hedge fund managers are driven to achieve above market returns. Managers who make bad investments could lose their jobs. They keep the wages they’ve saved up during the good times. If they bet large, and correctly, they make tons of money. If they lose, they don’t lose their personal money. That makes them very risk tolerant. It also makes the funds precarious for the investor, who can lose their entire life savings.

Hedge fund use of derivatives added risk to the global economy, setting the stage for the financial crisis of 2008. Fund managers bought credit default swaps to hedge potential losses from subprime mortgage-backed securities. Insurance companies like AIG promised to pay off if the subprime mortgages defaulted. 

This insurance gave hedge funds a false sense of security. As a result, they bought more mortgage-backed securities than was prudent. They weren’t protected from risk, though. The sheer number of defaults overwhelmed the insurance companies. That’s why the federal government had to bail out the insurers, the banks, and the hedge funds.

The real hedge in the financial system was the U.S. government, backed by its ability to tax, incur debt and print more money. The risk has been lowered a bit, now that the Dodd-Frank Wall Street Reform Act regulates many hedge funds and their risky derivatives. 

Example

Gold can be a hedge during times of inflation because it keeps its value when the dollar falls.

Gold is a hedge if you want to protect yourself from the effects of inflation. That’s because gold keeps its value when the dollar falls. In other words, if the prices of most things you buy rises, then so will the price of gold.

Gold is attractive as a hedge against a dollar collapse. That’s because the dollar is the world’s global currency, and there’s no other good alternative right now. If the dollar were to collapse, then gold might become the new unit of world money. That’s unlikely because there is such a finite supply of gold. The dollar’s value is primarily based on credit, not cash. But it wasn’t too long ago that the world was on the gold standard. That means most major forms of currency were backed by their value in gold. Gold’s historical association as a form of money is the reason it’s a good hedge against hyperinflation or a dollar collapse. 

Many people invest in gold simply as a hedge against stock losses. Research by Trinity College in Dublin revealed that, on average, gold prices rise for 15 days after stock market crashes.   

Gold can be bought as a direct investment if you think the price will go up, either because the demand will increase, or the supply will decline. That reason for purchasing gold is not a hedge.

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