Hedging is often considered an advanced investment strategy, but the principles are quite simple.
With the rise in popularity of hedge funds and the criticism that accompanies them, the practice of hedging has become quite common. Despite this, there is still a lot of misunderstanding in this area.
What is hedging
Most people, whether they know it or not, hedge regularly.
For example, if you buy a life insurance policy to support your family in the event of your death, this is a hedge.
You pay money monthly for the services provided by the insurance company.
While the textbook definition of a hedge is an investment made to limit the risk of other investments, in the real world an example of a hedge is insurance.
When trading options , investors use a put option as an insurance policy to protect themselves from losses if the instrument they have purchased falls in value.
Risk hedging example
Hedging, as the word is used on Wall Street, is best explained with an example.
Imagine that you want to invest in the fledgling bungee cord industry.
You know about a company called Plummet that modifies materials and designs to make products twice as good as its closest competitor, Drop.
So you think Plummet’s share price will go up over the next month.
Unfortunately, the bungee cord industry is subject to drastic changes in laws and safety standards, meaning it is quite volatile.
This is called industry risk. No matter what, you believe in the company and just want to find a way to reduce industry risk.
In this case, you can hedge the trade by going long Plummet and short the competitor’s Drop . The value of the shares involved will be $1,000 for each company.
If the industry as a whole goes up, you make a profit on Plummet, but lose on Drop – while it is desirable that you still remain in the black.
If the industry takes a hit, like if someone dies while bungee jumping, you lose money on Plummet but make money on Drop.
Basically, your total profit from a long position is minimized in order to reduce industry risk.
This method is sometimes referred to as pair trading . It helps investors gain a foothold in unstable industries or find companies in sectors that are characterized by some kind of systematic risk.
Risk hedging methods
Today, hedging covers all areas of finance and business.
For example, a corporation may decide to build a factory in the country to which it exports its products in order to hedge against currency risk .
An investor can hedge his long position with a put option , and a short seller can hedge his position with a call option .
Futures contracts and other derivatives can be hedged using synthetic instruments.
In principle, for any investment there is some form of hedging. In addition to protecting investors from various types of risk , hedging makes the market more efficient.
One obvious example of this is when an investor buys stock options to minimize the risk of a fall in their price.
Let’s say an investor owns 100 shares of a company, and over the past year, those shares have risen from $25 to $50.
The investor still likes these stocks and sees them as promising, but is worried about the correction that could accompany such a strong move.
Instead of selling shares, an investor can buy one put option , which gives him the right to sell 100 shares of the company at the strike price before expiration.
If an investor buys a put option with a strike price of $50 and an expiration of three months, he is guaranteed to receive a sell price of $50 no matter what happens to the stock over the next three months.
The investor simply pays a premium for the option, which essentially provides some insurance against the risk of a price drop.
Outcome
Hedging is often unfairly confused with the activities of hedge funds.
Hedging – in an investment portfolio, in business or in any other business – is to reduce or transfer risk.
That is, it is an effective strategy that helps protect your portfolio, home and business from uncertainty.
As with any trade-off between risk and reward, hedging results in lower returns than if you put all of your funds in volatile investment vehicles.
But it also reduces the likelihood that you will go around the world. Many hedge funds, on the other hand, take risks that people want to avoid.
By taking on this additional risk, they expect to receive a corresponding reward.
