What is Hedging – Protecting Your Investments
Joy Wallet is advertiser-supported: we may earn compensation from the products and offers mentioned in this article. However, any expressed opinions are our own and aren't influenced by compensation. To read our full disclosure, click here.
Investors are always trying to maximize gains and reduce losses and they look for different trading strategies for the same. One such strategy is hedging and it is widely in practice today. An investor can hedge against anything, including interest rates, stocks, currencies, or commodities.
Hedging is the process of buying an investment that helps reduce the risk of losses from another investment. A lot of investors choose an opposite investment to do this like using a put option to hedge against the losses in their stock position because a loss in the stock will be offset by a gain in the option. It is a way of getting portfolio protection, which is as important as portfolio appreciation. Even if you are a beginner investor, it helps to learn what hedging is and how it works.
In this article
Understanding hedging
Hedging is nothing but a unique financial strategy that gives investors a chance to reduce the downside effect of the investment in securities like stocks, bonds, currencies, commodities, options contracts, and forward contracts. It may not eliminate the risk of losing your money but it does help mitigate the risk. This is why it is a useful tool for investors who want downside protection on their investments.
It is a useful risk management strategy with the primary goal of cutting or severely reducing the risk of making losses in investments due to the volatility of the market. Hedging will offset the uncertain risks by reducing the trading losses and helping you lock in profit on a certain trade.
You can hedge an asset or investment by choosing to invest in another investment or asset and protect yourself against the loss. It is a strategy that can be used by large investors including institutional investors, portfolio managers as well as small investors. The purest form of hedging is life insurance. You make regular premium payments and the insurance company agrees to pay a lump sum in case of your death, thus giving financial security to your family in your absence.
Use Motley Fool's Stock Advisor To Invest
- Over 100 Stock Picks with 100%+ Returns
- Averaged Stock Pick Return over 593% (vs. 165% for the S&P)
- 2 New Stock Picks Every Month
- Investment Community With 700,000+ Loyal Members
- 30-Day Membership-Fee-Back Guarantee
- Joy Wallet Reader Deal: The Motley Fool is offering 50% off its top stock-picking service for new members (Limited Time)
How does hedging work
There are many ways to hedge investment and one of the most common methods is with futures contracts or derivatives. Let us understand with an example. If you own the shares of a stock, you can purchase an out-of-the-money put option to stay safe if the price of the stock declines significantly. Another example would be shorting a stock index through futures so as to protect the portfolio from the impact of a market correction.
Alternatively, you can invest in a company to protect yourself from the industry's weakness and buy the stock while also shorting one of the weaker competitors of the company. So, there are multiple ways you can hedge the investments, as long as there is an asset that can be reasonably expected to increase in value while the other goes down.
Professional traders, corporations, and individual investors use hedging to reduce the exposure to risks but in the financial market, hedging is not as simple as paying a premium and enjoying protection. It is all about strategically using market instruments to offset the risk of an adverse price movement. Investors can hedge one investment by making a trade-in another and for many years, precious metals like gold and silver were used as a hedge against inflation.
However, hedging does not eliminate the risk altogether but it will help lessen the impact of a devastating event. You can think of hedging as buying an insurance cover. You may have to pay a deductible if you need to use it but it is better than having no cover at all. The insurance premium helps reduce the risk but if you have no insurance cover, all your money is gone.
Different ways you can hedge
Through Derivatives
You can execute hedging using an investment instrument called derivatives which are the put and call options. An option is a type of derivative and its price will depend on the underlying asset. Hence, the value of the option is connected to the price of something else. As the holder of an option, you get the right to buy or sell at a price agreed upon before the expiry of the option but it is a right and not an obligation. When you buy stock through options, it is known as a call option since you call for delivery and when it allows you to sell the stock at a specific price, it is known as a put option. A long position means you have purchased the stock and own it while a short position means you have not bought them yet.
Let us understand how it works. You own stock in XYZ company and are certain about the prospects of the company but bearish on the sector. So, you can protect yourself from this by buying a put option on XYZ stock. It will give you the right to sell the stock at a certain price and at a specified time. Hence, when the stock falls below the price you have set for the put option, you will make some money back through the profits you have earned on the option.
Through futures
Investors can also use futures to hedge against a possible negative outcome. For example, In an organization, if the senior executives are worried about the rising cost of raw materials that help make a product, they could buy a futures contract to lock in the lower prices of the raw materials, thus avoiding the impact of the upward spike in the prices in the near term.
But there is a risk that the cost of raw materials may decline and the future locked-in price could be much higher than the actual cost of material when the contract was executed. In this case, the senior executives will lose money but it is important to do the homework and then make a move.
Through asset allocation
Financial advisors and portfolio managers often hedge the funds through diversification. It is possible to use hedging by diversifying the portfolio in stocks, mutual funds, bonds, cash, and money market instruments. It ensures that the losses in one particular investment offset the losses in another. Hedge funds are similar to mutual funds but they are more aggressive and risky, they try to maximize returns and reduce the risk for the investors.
Through stock market investment
If you are into stock investing and want to minimize the risk of losses, you can consider hedging. Let us take an example to understand it better. You buy 500 shares of Apple and think that the tech sector is going to perform exceptionally well over the next few years. Currently, Apple stock trades for $165.75, so this investment will cost you $82,875. If you are long shares, you can purchase a put option to protect the investment from a huge downside but you will have to pay a premium for it.
Assume that you find this investment a little risky right now considering the several macroeconomic factors and you want to hedge the position by purchasing 10 put option contracts that will allow you to sell the shares for $150 before the next four months, i.e., August 12. The premium you pay is $100 per contract and the 10 contracts will cost you $1,000.
Now, if the stock falls to $140 a share in the next four months, you can protect yourself from huge losses by exercising your contract and selling the shares at the strike price of $150, thus cutting the losses if the stock continues to sink further.
Hence, the hedge would result in a lower loss and is much better than the loss you would have made if you didn’t hedge. A reduction in risk means a reduction in the possibility of generating profits. Hence, hedging is about reducing the loss and not maximizing the gains, it can also reduce the gains to some extent. When you make an investment when an asset is dipping, you have automatically reduced the potential losses.
Use Motley Fool's Stock Advisor To Invest
- Over 100 Stock Picks with 100%+ Returns
- Averaged Stock Pick Return over 593% (vs. 165% for the S&P)
- 2 New Stock Picks Every Month
- Investment Community With 700,000+ Loyal Members
- 30-Day Membership-Fee-Back Guarantee
- Joy Wallet Reader Deal: The Motley Fool is offering 50% off its top stock-picking service for new members (Limited Time)
Types of investment risks
In any hedging strategy, your purpose is to mitigate risks. There are various types of investment risks and you will face them when you apply hedging strategies. Let us understand all the types of risks you need to be aware of.
Securities risk
It involves common stock and preferred stock, funds, futures, stock indexes, and stock options. The risk is that the investment used to hedge against other securities may move in the opposite direction and you could make losses.
Commodities risk
Hedgers often move towards commodities like oil or gas, precious metals, and several other commodities to protect from investment risk. A classic example of hedging involves a company that is dependent on a commodity. Assume that the company is worried about the fluctuations in the price of wheat since they use it as a raw material. This company would be in trouble if the price were to jump high as it could impact their profit.
To protect from the uncertainty of the wheat prices, the company can enter into a futures contract which is known as a forward hedge. It is a hedging instrument through which the company can buy an underlying asset, in this case, wheat at a specified price at a set date in the future. This will allow the company to budget without worrying about the price changes of wheat. Even if the price skyrockets, the strategy will pay off because it will save money and if the price falls, the company is still obligated to pay the price specified in the contract.
Currency risk
Institutional investors and large companies often use currencies like yen, pound, or dollar as a hedge on the price paid towards goods and services. There is the risk of the currency losing value due to the inherent market risk. Through hedging, it is possible to reduce the losses in case of a change in the exchange rate.
Rate of interest risk
Most investors tend to hedge against the interest rate movement by purchasing futures and options that have favorable interest rates. Swaps can be used for hedging, for example, interest rate swaps can hedge against the movement in interest rates.
Pros and Cons
Pros
- Balance out the risk. There is always risk associated with any type of investment product you choose. You can protect the investment by hedging a fund, security, or bond against the other to reduce the risk of losing all the amount of money on the original investment.
- Helps companies manage debt. Several organizations consider hedging as an ideal policy to handle debt. With hedging, companies can manage the debt capacity and balance out the other investments to reduce the amount of money they can lose on the investments.
- Helps with diversification. Experts recommend diversification of your investment portfolio and there is no better way to enjoy high diversification than hedging. With the appropriate allocation of assets, you will have low-risk exposure and solid investment performance.
Cons
- Costs. Hedging comes at a cost and before you dive into it, you need to compare the costs and benefits. You need to remember that you are not here to make money but to reduce the losses. The cost should not be more than the loss you are trying to avoid.
Use Motley Fool's Stock Advisor To Invest
- Over 100 Stock Picks with 100%+ Returns
- Averaged Stock Pick Return over 593% (vs. 165% for the S&P)
- 2 New Stock Picks Every Month
- Investment Community With 700,000+ Loyal Members
- 30-Day Membership-Fee-Back Guarantee
- Joy Wallet Reader Deal: The Motley Fool is offering 50% off its top stock-picking service for new members (Limited Time)
The bottom line
Not all investments are ideal for hedging and if you are confident about the performance of your stocks, in the long run, there is no need to spend any money on hedging instruments. However, if any of the stocks have shot up higher than you thought they would or you made a trade for a short-term profit, hedging can be a good idea for you to reduce the downside risk.
Understandably, all investors want to enjoy appreciation of their financial instrument and we are all here to make money. But asset protection remains equally important and when there are no steps taken to protect yourself from the risks, you could easily lose your way and end up with the wrong investments. This is where hedging makes all the difference. Through the right investment strategies, you can have a cushion against the potential losses that could put a huge dent in your financial future. Whether or not you decide to use hedging, it helps to have an understanding of the market. After all, it is the financial market’s way of protecting yourself from a loss.
Joy Wallet is an independent publisher and comparison service, not an investment advisor, financial advisor, loan broker, insurance producer, or insurance broker. Its articles, interactive tools and other content are provided to you for free, as self-help tools and for informational purposes only. They are not intended to provide investment advice. Joy Wallet does not and cannot guarantee the accuracy or applicability of any information in regard to your individual circumstances. We encourage you to seek personalized advice from qualified professionals regarding specific investment issues. Featured estimates are based on past market performance, and past performance is not a guarantee of future performance.
Our site doesn’t feature every company or financial product available on the market. We are compensated by our partners, which may influence which products we review and write about (and where those products appear on our site), but it in no way affects our recommendations or advice. Our editorials are grounded on independent research. Our partners cannot pay us to guarantee favorable reviews of their products or services.
We value your privacy. We work with trusted partners to provide relevant advertising based on information about your use of Joy Wallet’s and third-party websites and applications. This includes, but is not limited to, sharing information about your web browsing activities with Meta (Facebook) and Google. All of the web browsing information that is shared is anonymized. To learn more, click on our Privacy Policy link.
Images appearing across JoyWallet are courtesy of shutterstock.com.
Editor
Vandita Jadeja is a financial writer and editor at Joywallet. She loves to read and write about money and brings a decade of experience from the financial industry.
Share this article
