Financial Literacy

Hedging: Explained

Hedging is a kind of investment strategy that helps people mitigate risk. While many people connect the concept of hedging to hedge funds, hedging occurs in day-to-day life as well. This strategy allows you to lower your risks, but you have to know what you are doing. Otherwise, you could end up getting lower returns than you expected.

hedging

What Is Hedging?

In your day-to-day life, you have most likely used hedging before. When you get car insurance, you are basically hedging your risk of getting into an accident. If you do not get into a car crash, then you end up losing all of the money you spent on your monthly premiums. When an accident happens, your insurance will help cover the costs of your medical bills and car repairs.

Stock markets use hedging in a similar way. When a portfolio manager or corporation invests in something, they want to lower their risk relative to reward. To do this, they can but financial instruments to protect their positions. Basically, the investor can protect their position on one investment by trading another investment.

Purchasing Options

One of the ways you can reduce your risk is by trading an option. For example, you could go long on shares of Tesla. To protect yourself, you can also purchase a put option in case the shares decline significantly in value.

Purchasing an option costs money, so it cuts into the profits you can earn. Many people are willing to pay this cost because they have a low tolerance for risk. They are happy to reduce their potential profits if it means that they are less likely to lose some or all of their investment.

When people use hedging, it is often through derivatives. These financial instruments are available in many styles, but the most popular ones are futures and options. By buying a derivative, you can offset losses from your overall investment by making gains through the derivative.

Futures and options were originally developed because of the agricultural industry. If you are a farmer, you have to invest in your seeds, fertilizer and other materials months ahead of time. You have no clue how much your wheat will be worth this fall because crop yields and changes in demand can cause massive price fluctuations. Because of this, farmers were one of the first groups to use forward contracts. Back in 1848, the Chicago Board of Trade created a cash market for grain farmers. Forward contracts began trading almost immediately.

With forward contracts, buyers agreed on the price that they will pay for the grain. By making this arrangement in advance, farmers can be confident about the amount of money they will earn. Meanwhile, retailers can lock in an affordable grain price.

Hedging Examples from the Stock Market

There are many types of hedging strategies. Another example can be found on Wall Street. For instance, we will assume that you recently read about ABC Car’s innovative designs and electric engines. Now, you believe that ABC Car will revolutionize the automobile industry.

Because the automobile industry is impacted by changes to the economy and regulations, you are concerned about the future of the overall industry. This concept is known as industry risk. To reduce some industry risk, you decide to go long on ABC Cars and short on XYZ Motors.

If the industry gains, you will likely earn money from your stake in ABC Cars. At the same time, you will likely lose money on your XYZ Motors position. Ideally, you will still make an overall profit. Fortunately, going short on XYZ Motors will allow you to limit your losses if the entire automobile industry suffers from new regulations or an economic contraction.

What Are the Advantages of Hedging?

The main reason why people use hedging is to lower risk. Even though you might spend money to reduce your risk level, the money is worth it if your original investment loses money. By using a hedge, you can offset potential losses.

What Are the Disadvantages of Hedging?

If your original investment pays off, you will lose money on your hedge. For example, you will lose the money you spent on car insurance when you do not get into an accident. Likewise, going short on XYZ Motors means that you will lose some money if the automobile industry performs well.

Most investors view these losses as acceptable. A hedge is basically an insurance policy against future losses. While you will not profit as much off of your investment if it does well, you also will not lose as much money if your investment sours.

Another disadvantage to hedging is the learning curve. Hedging can be complicated. If you do not have experience with hedging, you may not know how to use this technique properly. Because you often have to pay for the price of the hedge upfront, you must spend money before you even have a chance to profit from your investment.

What Are the Different Types of Hedging?

There are many types of hedging you can use…

  • Currency future contracts
  • Forward exchange contracts for interest or currencies
  • Short straddles on indexes or equities
  • Money market operations for interest or currencies
  • Covered calls on stocks
  • Future contracts for interest

Additionally, you can use different hedging strategies. With a risk reversal, you can sell a put option and buy a call option. Meanwhile, back-to-back hedging is where you can close any open position by buying the financial instrument on the spot market. For example, your local gas company may purchase the exact amount they need from the commodity market when a factory makes a large purchase. Back-to-back trading carries a degree of risk because the gas company does not know if the gas contract will be available when they need to buy it.

With Delta hedging, investors can reduce the risk of an option by hedging against price fluctuations in the underlying stock. Tracker hedging is when the open position drops as the maturity date approaches. For example, an electricity provider may purchase half of the natural gas they need in the summer. As they get closer to winter, they will have a better understanding of how much heat people will actually use. Once winter arrives, they can purchase the remainder of the natural gas they need.

While some types of hedging only work for institutional investors, basic hedging can be done by individual investors. Before you try any hedging technique, it is important to research hedging and your prospective investments. Hedging can reduce your risks, but you have to know what you are doing.

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Read Next: Put Options – An Introduction and How to Trade Them


About

Ben Broadwater is the Director of Investment U. He has more than 15 years of content creation experience. He has worked and written for numerous companies in the financial publishing space, including Charles Street Research, The Oxford Club and now Investment U. When Ben isn’t busy running Investment U, you can usually find him with a pair of drumsticks or a guitar in his hand.

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