What is a hedge?

In finance, to hedge is to balance an existing position with an asset or investment to lessen price risk. A hedge aims to reduce the risk of adverse price changes in another asset. One takes the opposing position in a linked or derivative investment to hedge an asset.

Hedge effectiveness is possible with derivatives due to their apparent link to underlying assets. Securities called derivatives move in sync with underlying assets. They include options, swaps, futures, and forwards. Assets include stocks, bonds, commodities, currencies, indices, and interest rates. A derivative trading technique can balance a loss in one investment with a gain in a related derivative.

How Hedge Works

Hedging is like insurance. If you live in a flood-prone location, you should buy flood insurance to protect your house. In this case, you cannot prevent a flood but may prepare for it.

Hedging involves a risk-reward tradeoff since it decreases risk and diminishes prospective benefits. Put simply, hedging costs: flood insurance policies have high monthly premiums, and if the flood never occurs, the insured receives no reimbursement. Most individuals would rather suffer that known, restricted loss than lose their home.

Investment hedging works similarly. Investors and money managers use hedging to control risk exposure. In investing, one must strategically employ multiple tools to hedge against market price changes. This is best done by making another focused and controlled investment. Of course, the insurance case has a few parallels: The insured would receive total compensation for flood insurance, maybe minus a deductible. Investment hedging is more complicated and imperfect.

A perfect hedge eliminates all risk in a position or portfolio. The hedge follows a 100% inverse correlation with the susceptible asset. Even the ideal hedge costs money. Basis risk is the risk that an asset and hedge will not move in opposing directions. “Basis” means the difference.

Derivative Hedge

The value of an underlying security determines the price of derivatives. Typical derivatives contracts are futures, forwards, and options.

The delta, or hedging ratio, measures the efficiency of a derivative hedge. Delta is the change in derivative price per $1 change in the underlying asset price.

The downside risk of the underlying security against which the investor wants to hedge will determine the hedging strategy and instrument pricing. Higher downside risk means higher hedge costs. Options with extended expiration periods and higher volatility are more expensive to hedge due to increased downside risk.

In the stock example, a higher strike price makes the put option more expensive but offers more price protection. Adjusting these variables creates a cheaper option with less protection or a more expensive one with more. Still, cost-effectiveness makes additional price protection unwise at some point.

Options and futures contracts let investors hedge against price changes in stocks, bonds, interest rates, currencies, commodities, etc.

Put Options Hedge Example

Put options are a common investment hedge. Put holders have the right but not the obligation to sell the underlying security at a pre-set price before expiration.

For instance, Morty may hedge his investment by purchasing a one-year put option with an $8 strike price for 100 Stock PLC (STOCK) shares at $10 per share. At any time next year, Morty can sell 100 stock shares for $8.

Assume he pays $1 for the option or $100 in premium. If STOCK is $12 next year, Morty will lose $100 by not exercising the option. His $100 unrealized gain—including the put price—shouldn’t worry him. If STOCK is selling at $0, on the other hand, Morty will execute the option and sell his shares for $8, for a loss of $300 ($300 plus the price of the put). Without the alternative, he stood to lose his whole investment.

Hedging Through Diversification

Using derivatives to hedge an investment enables precise risk calculations, but it requires a measure of sophistication and often quite a bit of capital. However, derivatives are not the only option to hedge. Strategically diversifying a portfolio to mitigate specific risks can also be called a hedge, albeit a very rudimentary one. For example, Rachel might invest in a luxury goods company with rising margins. She might worry, though, that a recession could wipe out the market for conspicuous consumption. One method to fight that would be to buy tobacco stocks or utilities, which tend to weather recessions well and generate high dividends.

This method has its tradeoffs: if wages are high and employment is plentiful, the luxury goods company would prosper, but few investors would be drawn to dull countercyclical businesses, which might plummet as capital moves to more exciting locations. It also has its risks. There is no guarantee that the luxury goods stock and the hedge will move in opposite directions. They could drop due to one catastrophic event, as happened during the financial crisis, or for two unrelated reasons.

Spread Hedging

In the index market, mild price losses are incredibly typical and unpredictable. Investors in this area may be more concerned with moderate declines than severe ones. In these instances, a bear put spread is a frequent hedging technique.

The index investor buys a put with a higher strike price in this spread. Next, she sells a put with a lower strike price but the same expiration date. Depending on how the index acts, the investor obtains a degree of price protection equal to the difference between the two strike prices (minus the cost). While this is likely to be a minor degree of protection, it is generally adequate to cover a temporary drop in the index.

Risks of Hedging

Hedging is a tactic to limit risk, but it’s crucial to remember that practically every hedging practice has drawbacks. First, as shown above, hedging is imperfect and is neither a guarantee of future success nor an assurance that any losses will be lessened. Instead, investors should think about hedging in terms of benefits and drawbacks.

Are the profits of a hedging strategy worth the increased expenditure it requires? Remember that an effective hedge typically saves losses, so earnings alone may not be enough. Many hedge funds produce money but generally use hedging tactics with their principal investments.

The Average Investor and Hedging

The majority of investors will never hedge. Some investors may never trade derivatives. One explanation is that long-term investors, like retirees, overlook daily security changes. Short-term volatility is not essential in these circumstances, as investments often rise with the market.

Hedging may appear unnecessary for buy-and-hold investors. Still, because large companies and investment funds hedge regularly and investors may follow or be involved with them, it’s helpful to understand hedging to track and understand their actions better.

Risk-hedging—what is it?

Hedging reduces financial asset risks. It hedges against price swings via financial instruments or market techniques. Investors trade to hedge one investment.

Examples of Hedging?

Hedging includes buying property insurance, using derivatives like options or futures to offset losses in underlying investment assets, or opening new foreign exchange positions to limit losses from currency fluctuations while retaining upside potential.

Hedging: An Imperfect Science?

Hedging in investment is often considered a complicated and imprecise science. A perfect hedge eliminates all positional or portfolio risk. The hedge inversely correlates 100% with the susceptible asset. Though hypothetical, the ideal hedge costs

The Verdict

Hedging helps investors and traders reduce risk. A hedge is an offsetting or opposing position that acquires or loses the same value as the primary position does. Hedging is like buying insurance for an investment or portfolio. Diversification or closely comparable assets can balance these investments. Derivatives, including futures, forwards, and options, are the most prevalent and effective hedges.

Conclusion

• Hedge strategies reduce financial asset risk.
• Offsetting derivative positions with existing positions is a common hedging strategy.
• Diversification is another way to build hedges. Examples include buying cyclical and countercyclical equities.
• Hedging protects investors from risk and improves market efficiency.