Investors and market analysts have probably heard the term “hedging” tossed around. The term “hedging” refers to the practice of reducing investment risk through the purchase of uncorrelated assets or the tactical deployment of cash. Although this term may make you think of something complicated and high-brow, the idea behind it is actually relatively straightforward.
Learn more about hedging and how it might benefit you below.
List of Contents
What is Hedging?
To hedge is to engage in a complex risk management plan, such as buying or selling an asset, in order to mitigate the loss of a current position. Individual investors rarely use the trading method of hedging, and when they do, it is usually after they have already made an initial investment. You wouldn’t use hedging to begin a buy or sell position.
Allow me to illustrate with a made-up hedging scenario. Let’s say in March; you invested $3,000 in 100 shares of AAPL stock at $30 per share. After a few months, the stock has risen to $25. Let’s pretend you’d rather not sell the stock (maybe because you believe it has further to grow and you’d rather not trigger a taxable event) but that you’d still like to limit your losses. Consider using a protective put technique, where you buy put options on the same stock to offset the risk of this position. Puts provide the buyer the opportunity to sell shares at a set price and time frame, but not the obligation to do so. Let’s say you choose to purchase enough $20 put options to hedge your current position adequately. In this case, you would be safe from further losses below $20 (for the duration of owning the put option).
How Hedging Works
As a complex method for reducing exposure to risk, hedging is an increasingly popular financial tool. To compare a hedge to an insurance policy is an apt metaphor. Theoretically, they can restrict the money you lose on an investment or the purchase cost. A hedge’s value typically rises when an investment’s value falls. The value of the hedging often decreases as the value of the underlying investment increases. Options, agreements to buy or sell an asset at a future date and price, are commonly employed in hedging techniques.
Two Main Factors Motivate Investors to Hedge:
Over-concentration
Having a large stock in a single firm makes you wary, so you look for ways to safeguard your investment.
Finance repercussions
Hedging is a strategy that allows you to protect the value of investment while postponing its sale.
Hedging by corporations, as opposed to individuals, can provide more confidence about future costs. Airline companies frequently engage in this kind of hedging by preemptively purchasing oil futures several months in advance. Hedging is used by airlines primarily to better predict and plan for future costs. The aviation industry would be highly vulnerable to fluctuating fuel costs if not protected by hedging.
Example of Hedging
Let’s say your bet on Apple stock paid off, and your 100 shares are now worth $175 each. You’re interested in keeping the shares, but you’re worried about a price drop if you wait too long.
If you want to protect your investment, you can buy a put option with a $160 strike price. The cost of locking in the current share price while maintaining the ability to sell at that price is reflected in the premium. Two weeks later, Apple released disappointing financial results, sending the stock price tumbling. When it reaches $160, you decide to end the bleeding by buying out your option.
If the stock price had remained stable or gone up, you would have let the option expire and been out the premium you paid. You would need to buy a new put option if you wanted to keep using this method.
Types of Hedging Strategies
Options, futures, and forwards are only a few examples of the derivatives commonly used by investors to construct hedges. Hedging can also be done via inverse ETFs, which are hazardous investments but may be a choice in some circumstances.
Protective Puts
To put it simply, a put option grants the holder the right, for a limited time, to sell their shares at a predetermined price. By setting the strike price at which the put is sold, you can ensure a minimum price at which your stock will not fall. Losses can be reduced or perhaps prevented entirely by using protective puts. However, they are not without cost; a premium must be paid. If your stock never falls below the strike price, you will lose money.
Covered Calls
A call option grants the holder the right to purchase a share of stock for a specific time and at a set price. Selling covered calls are one way to protect your investment in Apple stock. As long as the stock doesn’t exceed the strike price, you’ll make money from the premiums the buyer pays for the calls. Therefore, you will get premiums on the covered call if the stock price falls as you anticipate. However, your profits would be capped at the strike price if the stock price reached that level.
Collars
Collars are a variation on the covered call and protective put. You can hedge against a possible decline in the stock price by purchasing put options, with the premiums you get from selling call options serving as a down payment on the cost of the put insurance.
What It Means for Individual Investors
Sometimes the cost of a hedge is high, and it is normal for that cost to change over time. That’s why they aren’t suggested for those who plan to buy and hold the stock. Take the time to learn about the premiums you’ll pay or receive and the strike price before committing to a hedge.
Should You Hedge?
If a company or investor has the personnel — such as those with the knowledge and experience to understand and implement hedges — hedging can be a valuable tool for helping them achieve their goals. However, it’s essential to remember that hedging can be a double-edged sword, especially if the investment used to hedge loses value or cancels out the benefit of the underlying increasing value.
There are several reasons why hedging isn’t always the best option for individual investors.
Complexity
In contrast to more conventional investments like stocks and bonds, hedging typically uses cutting-edge investment vehicles. It would be best if you didn’t even think about using hedging unless you have a firm grasp on the underlying hedging instrument. And even if it is, it might not work.
Cost
There are extra outlays in hedging. An expense, such as purchasing options, is associated with taking a new position.
Effectiveness
There is still a chance that hedging won’t work, even if done correctly. Take the hypothetical case of an airline that hedges its future exposure to jet fuel price, only to see fuel prices drop after the hedge goes into effect. Please also consider the viewpoint of an individual who chooses to invest in a mutual fund or ETF that seeks to diversify its holdings: It may be difficult to easily hedge off only the parts of the fund that you believe are vulnerable to loss.
Suitability
It’s possible that long-term investors shouldn’t bother with hedging. Take the case of a stock purchase with the expectation of holding it for more than a year. You have reason to believe the stock is vulnerable to short-term loss after observing it for a couple of months. If you plan to hold the stock for an extended period, it may not make financial sense to hedge that risk exposure due to the associated costs.
Consequently, it is prudent to oversee your investments to ensure a balanced portfolio consistent with your goals and tolerance for risk. As an investor, you can mitigate the unique dangers associated with each stock by spreading your holdings across a diversified portfolio. While neither hedging nor diversification can guarantee a loss, the former is typically more helpful to the average investor than the latter.
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Source: Fidelity, The Balance