A hedge is a measure taken to reduce the risk of volatile price movements in an asset. A hedge is an investment that consists in taking an offsetting position on the security in question which helps protect it from large price drops.

What is hedging?

Hedging is a trading strategy that helps protect your valuable assets. If you own a house near a river which floods during heavy rainfall, it makes sense to be financially protected when it happens. One way to do it is to cover the potential damages with flood insurance - basically hedging the risk of flooding. It’s not always possible to predict undesirable events, but you can at least protect your assets from them by implementing a hedging strategy.

Hedging works in a similar way when it comes to trading and investing. Traders and investors use hedging to protect their investments from volatile market risks. However, in the investment world, hedging requires various strategies and financial instruments in order to protect different assets in different situations.

In our flood insurance example above, the policy alone would ensure that you get fully compensated. When it comes to investing, hedging isn’t so simple. 

In theory, you can fully eliminate the risk of your position or portfolio by implementing a perfect hedge. The perfect hedge means that you use a hedge that has a 100% inverse correlation to the asset that you’d like to protect. However, that’s very difficult to do in practice.

While hedging is a great way to mitigate some of the trading risks, it comes at a cost. Just like with insurance, you might get reimbursed for your costs, but you still need to pay a premium price until the event you’re protecting your assets from, happens.

How does hedging work?

Now that we’ve seen what hedging is, we’re going to discuss how hedging works.

Several options are available if you decide to hedge your investments. 

One of the commonly used ones is the derivatives/futures contract method. If you own shares of a stock, for example, you could purchase the out-of-money put option which would protect you in case of a large drop in price of the stock in question.

Another method would be to short the stock index through futures, which would help you protect your entire stocks portfolio.

If you’re looking to protect yourself from weaknesses in a certain industry, you could buy stocks of one company in that industry while shorting the company’s weaker competition.

In practice, there are many ways to hedge your investment risk, as long as you’re confident that the asset you’re using to hedge is inversely correlated with the asset you’d like to protect.

Example

Let’s say you want to buy 50 shares of Netflix because you think it will have good business performance in the future. If the cost is 100€ per share, you will pay 5,000€ for the shares.

If you consider the investment slightly risky due to upcoming leadership changes at Netflix, you can decide to hedge your investment. You buy an option contract that lets you sell shares at 85€ within a certain period (nine months for example). You also pay 120€ for the contract. 

It turns out you were right. The change in leadership caused the Netflix stock price to drop to 40€ per share five months later. Your investment is now worth only 2,000€ with a loss of 3,000€. However, because you decided to buy the option contract, you can sell the shares at 85€ per share for a total of 4,250€.

Your final loss is 750€ plus the 120€ you paid for the put options contract. This brings the total to 870€, which is 2,130€ less than the 3,000€ you would have lost otherwise.

Spread hedging

When it comes to trading indices, smaller drops in price happen often and they can be difficult to predict. If your trading strategies focus on these instruments, it might be a good idea to use a bear put spread strategy for hedging.

You can do this by first purchasing a put that has a higher strike price. After that you should sell a put for a lower price but with the same date of expiry. This method allows you to have a degree of price protection equal to the difference between the two strike prices, according to the price movements of the index in question.

Hedging risks

Even though hedging is used to minimize (or hopefully fully eliminate) risk, you need to know that each hedging method carries with it its own risks. As mentioned earlier, hedging is rarely perfect and can’t guarantee successful trading or loss mitigation.

However, hedging is still more often than not a great way to reduce your trading risks and, as long as you keep in mind all the pros and cons, you can use it to secure your trades. It’s also important to keep in mind that the primary purpose of hedging is not to help you increase profits, but to avoid losses.

Conclusion

Hedging is a common strategy used by traders and investors to manage the risk. Risk is an inherent element of investing so it’s important to study different risk management strategies employed by professional investors and companies. This will make you a better trader and help you develop a thorough understanding of the market.

 

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