What is hedging and how does it work?

You may have heard investors or financial market commentators talk about hedging. Hedging is a way to reduce your risk by buying other types of investments or by strategically using cash. Although it may seem complex and sophisticated, the concept of coverage is actually quite simple.

Here’s what you need to know about coverage and how it works.

What is a hedge?

Hedging is an investment that limits your financial risk. A hedge works by holding an investment that will move in the opposite direction to your base investment, so that if the base investment declines, the investment hedge will offset or limit the overall loss.

Hedges come in many forms and include the use of derivatives such as options to limit your risk, as well as less complex assets such as cash. Some investors resort to short selling to hedge their exposure to certain risks and build their portfolios in such a way as to take advantage of them in the event of a market decline.

A hedge that most people use without realizing it is diversification. Holding a diversified portfolio is essentially admitting that you don’t know which investments will perform best. So you hedge that risk by exposing yourself to many different sectors of the market. You hold cyclical and non-cyclical stocks, stocks and bonds or other investments that benefit from different economic environments. When one goes up, the other usually goes down. If you knew exactly what the future held for you, you wouldn’t need to diversify.

How the cover works

Hedging can take many different forms, but one of the most common ways is through the use of derivatives, which derive their value from an underlying asset such as stocks, commodities or indices such as the S&P 500. By using a derivative linked to the underlying asset you are looking to hedge, you can directly limit your risk of loss. Here’s how it works.

Suppose you bought a stock at $100 a share, but you’re worried that an upcoming earnings announcement will disappoint investors and send the stock plummeting. One way to limit your exposure to this potential loss would be to buy a put option on the stock with a strike price you are comfortable with. A put option with a strike price of $95 would allow you to sell the stock at $95 even if the stock falls well below that level.

Here’s what could happen if the stock goes up or down:

• If the stock drops to $80 per share, you can exercise your put option at $95. The hedge fully protects your stock investment in the fall of $95-$80, so your loss is limited to $5 per share ($100-$95) plus the cost of the option.
• If the stock rises to $110 per share, you will realize the $10 gain from the stock price increase, while the option will expire worthless. Your net gain will be $10 per share minus the cost of the option.

Large companies often use derivatives to hedge their exposure to input costs to manage their risk. Airlines typically hedge jet fuel costs so they are not exposed to daily fluctuations in the spot market, while food companies may hedge the prices of key ingredients such as corn or sugar.

Of course, there are also simpler ways to protect yourself. Some investors hold a portion of their portfolio in cash to protect against a market downturn, while others diversify by asset class or geographic region.

Benefits of coverage

• Risk Mitigation – The main benefit of hedging is the ability to manage the risk and investment exposure you have. Derivatives can be used to protect you if things don’t go the way you expect.
• Limit losses – Hedging allows you to limit your losses to an amount that suits you. The cost of hedging will limit your advantage, but you can be sure that your losses won’t swell if prices go down.
• Pricing Clarity – Companies and even individuals such as farmers use derivatives to remove uncertainty from future commodity prices. By using forward and forward contracts, they can lock in the prices of key goods well in advance of their delivery date.

Hedging risks

• Limit Winnings – While limiting your losses is one of the main benefits of hedging, it also means that it will limit your potential gains. If an investment eventually appreciates and hedging is not needed, you will lose the cost of hedging. Similarly, if a farmer agrees to sell corn at a certain price in the future, but the spot market is at even higher prices when the corn is delivered, the farmer will have missed out on those higher profits.
• Costs – Hedging has a cost, either the direct cost of a derivative contract used to hedge, or the cost of lower earnings in exchange for some protection. Make sure you understand all the costs associated with a hedge before going ahead with it.
• Bad analysis – It’s possible that the investment you thought was a good hedge isn’t so good after all. Imagine you own airline stocks, but are worried that higher fuel costs will impact corporate profits. You might buy a basket of energy companies as a hedge, thinking that their higher profits will outweigh any negative impact felt by the airline industry. But a widespread economic downturn could cause the price of oil and demand for travel to plummet, hurting both industries and making your coverage less than perfect.

Should you consider hedging your investments?

For most long-term investors, hedging is not a strategy you should pursue. If you’re focusing on a long-term goal like retirement, you don’t have to worry about day-to-day market fluctuations and hedging could end up doing more harm to your portfolio than good. Remember that you are rewarded in the long term with higher returns for enduring the short term volatility that comes with investing in the stock market.

For those with a more active investment philosophy or trading mindset, hedging can be a smart way to manage your risk, but make sure you understand the costs associated with any hedging and the relationship hedging has to your investments.

At the end of the line

Hedges can be used to manage risk in the investment world, but they come with lower costs and potential returns. For most investors aiming for long-term goals, hedging won’t be necessary and could actually hurt your long-term returns. Consider holding low-cost index funds in good times and bad, which has proven to be a good strategy for decades.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. Further, investors are cautioned that past performance of investment products does not guarantee future price appreciation.