An Introduction To Hedging

For investors who have developed a relatively good understanding of long position based investing, a “next step option” could be to explore hedging. Similar to corporations, funds, and professional portfolio managers, individual investors can utilize hedging strategies in order to reduce their exposure to varying risks. That said, with regard to financial markets, hedging can be much more complicated than just purchasing insurance (i.e. protecting your car or home as an investment.) Instead, to hedge again risk in the financial markets, investors tactfully use different market instruments to counterbalance adverse price movements. Essentially, investors use one investment as a hedge for another — which is often done using two assets with negative correlations.

With this information in mind, it is important to remember that using a “hedge strategy” does not mean that investments will be risk-free with limitless profit potential. In reality, hedging (and reducing risk) will also reduce potential profits since you are taking a position with a negative correlation (to create the hedge).  Consequently, some investors do not view hedging as a tool to make money, but instead a way to reduce potential losses. Accordingly, if the investment you are hedging against becomes profitable, you will have cut into your profits, but if it loses money your hedge will have been successful in reducing the loss.

When investment professionals implement hedging techniques they typically use complicated financial instruments called “derivatives.” Moreover, the two most common derivatives are called “options” and “futures.” To understand the basics of hedging (and within the scope of this article) it is not necessary to understand how derivatives work, however, it is important to know that, using these instruments, an investor can create trading strategies whereby a loss in one investment is offset by a gain in a derivative.

So, what does a hedging strategy look like in the real world? As an example, imagine you own stock in an auto company (XYZ) and believe that it will succeed in the long run. However, you have concern about short-term losses in the auto industry as a whole. In this scenario, a possible way to protect yourself from a fall in XYZ’s price would be to buy a put option (derivative) on the company, which would give you the right to sell at a specific price (strike price) — a strategy referred to as a “married put.” In doing so, if XYZ’s price fell below the strike price, the losses would be offset by gains in the put option (the hedge).

Admittedly, many casual investors never trade a derivative contract in their whole time playing the markets. Likewise, it is not uncommon for them to ignore the “short position” markets completely. That said, there are still benefits to understanding the concept of hedging. For example, even if you do not hedge in your own portfolio it is important to grasp because so many large companies (and funds) use the strategy in some form. As such, an understanding of the strategy might help you to better comprehend the investments they make and how they might affect your own long-biased portfolio. In the end, knowledge is power in the world of investing and the more information you can collect from different types of professionals the better. That is not to say that increased information will automatically increase returns, however, it is a great place to start!