What Is a Hedge?

Hedging is a strategy to limit investment risks. Investors hedge an investment by trading in another that is likely to move in the opposite direction. A risk-reward tradeoff is inherent in🐬 hedging; while it reduces potential risk, it may chip away at potential gains.

How a Hedge Works

Using a hedge is a bit like taking out an insurance policy. If you own a home in a flood-prone area, you can protect it from the risk of flooding—ওhedge it, in other words—by taking out flood insurance. You cannot eliminate the risk of a flood, but you can mitigate the financial losses you could inc๊ur.

Similarly, if you invest in a hot technology company with the firm belief that its business will thrive over the next quarters, you might also invest in a solid consumer staple stock just in case you're mistaken.

The Downside to a Hedge

Hedging isn’t free. In the case of the flood i🌼nsurance policy example, the monthly payments add up, and if th🅷e flood never comes, the policyholder gets nothing. Still, most people would choose to limit their losses.

In the world of professional investing, hedging works in the same way. Investors and money managers use hedging practices to reduce and control their 澳洲幸运5开奖号码历史查询:risk exposure. They use various tool𒈔s for the pu꧃rpose, many based on derivatives.

Hedging With Derivatives

Derivatives are financial contracts 🍬whose price depends on the value of an underlying security. Futures, forwards, and options contracts are common types of derivative contracts.

The effectiveness of a derivative hedge is expressed in terms of its delta, sometimes 🌳called the hedge ratio. Delta is the amount that the price of a derivative moves per $1 movement in the 🎐price of the underlying asset.

The specific hedging strategy, as well as the pricing of hedging instruments, depends large🧸ly upon the downside risk of the underlying security against which the investor wants to hedge. Generally, the greater the downside ꦯrisk, the greater the cost of the hedge.

Downside risk tends to increase with higher levels of volatility and over time; an option that expires after a longer period, which is linked to a volatile security, will be more expensive as a means of hedging.

In general, the higher the strike price, the more expensive the put option will be, but the more price protection it will offer as well. These variables can be adjusted to create a les𝄹s expensive option that offers less protection, or a more expensive one that provides greater꧋ protection.

Example of Hedging With a Put Option

A common method for hedging is through put options. Puts give the holder the right, but not the obligation, to sell the underlying security at a 🧸pre-set price on or before the date it expires.

For example, if Morty buys 100 shares of PLC stock at $10 per share, and hedges the investment by purchasing a 澳洲幸运5开奖号码历史查询:put option with a 澳洲幸运5开奖号码历史查询:strike price of $8 expiring in one year. This option gives Morty the right to sell 100 shares of that stock for $8 per share anytime in the next 𝔉year.

Let’s assume Morty pays $1 for the option, or $100 in premium. If the stock tr♒ades at $12 one year later, Morty will not exercise the option and will be out $100:

• $1,000 for the stocks and $100 for the option = $1,100
• Stock appreciates to $1,200
• $100 lost by not exercising the option
• But gains $100 ($1,200 - $1,000 paid for stock - $100 paid for option)

If the stock price ꦿfell to $0, Mortꦓy would exercise the option and sell the shares for $8, for a loss:

• $1,100 for stocks and the option
• Sold shares for $800
• Total loss of $300

Without the option, 🍷Morty would have lost the entire investment of $1,000.

Hedging Through Diversification

Strategically 澳洲幸运5开奖号码历史查询:diversifying a portfolio to reduce certain risks can also be considered a hedge. For example, Rachel might invest i🃏n 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 w๊eather recessions well and pay hefty dividends.

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 countercyclical stocks, which might fall as capital flows to more exciting places.

It also has its risks: There is no guarante😼e 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.

Spread Hedging

For investors in index funds, moderate price declines are quite common and highly unpredictable. Investors focusing on this area may be more concerned with moderate declines than severe ones. In these cases, a 澳洲幸运5开奖号码历史查询:bear put spread is a common hedging strategy.

In this type of spread, the index investor buys a 🃏put that has a higher strike price. Next, they sell a put with a lower strike price but the same expiration date.

Depending on how the index behaves, the investor has a degree of price protection equal to the difference between the two strike prices (minus the cost). While this is likely to be a moderate a🔯mount of protection, it is often sufficient to cover a brief downturn in the index.

Hedging and the Everyday Investor

Most individual investors don't trade derivative contracts. Investors with a long-term strategy, such as those saving for retirement, can ignore the day-to-day fluctuations of the markets.

For investors who fall into the buy-and-hold category, there may seem to be little or no reason to learn about hedging. Still, because large companies and investment funds tend to engage in hedging practices regularly, and because these investors might follow or even be involved with these larger financial entities, it's useful to understand what hedging entails to comprehend the actions of these larger players.

The Bottom Line

Hedging is an important financial c🍨oncept that allows investors and traders to minimize various risk exposures. A hedge is effectively an offsetting or opposite position taken that will gain (or lose) in value as the primary position loses (or gains) value.

A hedge can be thought of as a type of 🎉insurance policy on an investment or a portfolio. These offsetting positions can be achieved using closely related assets or through diversification.

Among professional traders, the most common and effective hꦦedge uses derivatives such as futures, forwards, or 𒅌options contracts.