Hedge: Meaning and How It Works in Investing

In finance, hedging means taking a position in an investment that balances out the risk of another existing investment. It’s a way to protect against price changes in an asset. A hedge is essentially a trade made to reduce the risk of losing money on another investment. Usually, hedging involves taking a different position in a related security or derivative security connected to the asset being hedged.

Derivatives can be good hedges because their relationship with the underlying assets is usually well-defined. Derivatives are financial products that move based on one or more underlying assets. They can be options, swaps, futures, or forward contracts. The assets underlying derivatives include stocks, bonds, commodities, currencies, indexes, or interest rates. You can use derivatives to create a trading plan where a loss in one investment is balanced out by a gain in a similar derivative.

How a Hedge Works

Using a hedge is like getting an insurance policy. If you own a house in an area prone to flooding, you’ll want to protect it from flood risks by getting flood insurance. In this case, you can’t stop a flood, but you can plan to reduce the damage if one happens.

Hedging involves a tradeoff between risk and reward. While it lowers potential risk, it also reduces potential gains. In simple terms, hedging isn’t free. For example, with flood insurance, you pay monthly, and if there’s no flood, you don’t get any payout. But most people would prefer to pay the predictable insurance cost than risk losing their home suddenly.

In investing, hedging works similarly. Investors and managers use hedging to manage their exposure to risks. To hedge properly, you use different tools strategically to offset the risk of price changes in the market. The best way is to make another investment in a controlled manner.

However, unlike flood insurance, hedging in investments is more complex and not perfect. In the case of flood insurance, the policyholder would be fully compensated for their loss, minus a deductible. In investments, hedging is more intricate and doesn’t guarantee complete protection.

Hedging Through Diversification

Using derivatives to hedge investments involves making precise risk calculations, but it requires sophistication and significant capital. However, there are other methods to hedge investments aside from derivatives. Diversifying a portfolio strategically to reduce specific risks can also serve as a hedge, though it may not be as precise.

For instance, let’s consider Rachel. She invests in a luxury goods company with increasing profit margins. However, she worries that during a recession, the market for luxury items might decline sharply. To address this concern, Rachel could invest in tobacco stocks or utilities instead. These types of investments usually perform well during economic downturns and often offer substantial dividends.

This hedging strategy comes with its pros and cons. When wages are high and jobs are abundant, the luxury goods company may thrive, but fewer investors may be interested in the less exciting countercyclical stocks. Furthermore, there’s a risk involved: there’s no guarantee that the luxury goods stock and the hedge will move in opposite directions. They could both decrease simultaneously due to a single catastrophic event, like during the financial crisis, or due to unrelated reasons.

Spread Hedging

In the world of indexes, moderate price drops happen frequently and are hard to predict. Investors who focus on this area might worry more about moderate declines than severe ones. When facing this situation, they often turn to a strategy called a “bear put spread” for hedging.

Here’s how it works: The index investor buys a put option with a higher strike price. Then, she sells a put option with a lower strike price but with the same expiration date. By doing this, the investor gains a level of protection against price drops equal to the difference between the two strike prices (minus the cost). While this protection may be moderate, it’s often enough to handle a short-term downturn in the index.

Risks of Hedging

Hedging is a method used to lower risk, but it’s crucial to understand that almost every hedging strategy comes with its drawbacks. Firstly, as mentioned earlier, hedging isn’t flawless and doesn’t guarantee future success or automatically reduce losses. Instead, investors need to weigh the advantages and disadvantages of hedging carefully.

FAQs