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Hedging is often considered an advanced investing strategy,but the principles of hedging are fairly simple.With the popularity–and accompanying criticism–of hedge funds,the practice of hedging became more widespread.Despite this,it is still not widely understood.

Everyday Hedges

Most people have,whether they know it or not,engaged in hedging.For example,when you buy life insurance to support your family in the case of your death,this is a hedge.You pay money in monthly sums for the coverage provided by an insurance company.Although the textbook definition of hedging is an investment taken out to limit the risk of another investment,insurance is an example of a real-world hedge.

[When trading options,investors leverage puts as an insurance policy to protect themselves from losses if the instrument they purchased decreases in value.To learn how successful traders use options to curb risk and increase earnings,as well as other basic options trading strategies,check out Investopedia Academy's Options for Beginners course.]

Hedging,in the Wall Street sense of the word,is best illustrated by example.Imagine that you want to invest in the budding industry of bungee cord manufacturing.You know of a company called Plummet that is revolutionizing the materials and designs to make cords that are twice as good as its nearest competitor,Drop,so you think that Plummet's share value will rise over the next month.

Unfortunately,the bungee cord manufacturing industry is always susceptible to sudden changes in regulations and safety standards,meaning it is quite volatile.This is called industry risk.Despite this,you believe in this company;you just want to find a way to reduce the industry risk.In this case,you are going to hedge by going long on Plummet while shorting its competitor,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–hopefully for a modest overall gain.If the industry takes a hit,for example if someone dies bungee jumping,you lose money on Plummet but make money on Drop.

Basically,your overall profit–the profit from going long on Plummet–is minimized in favor of less industry risk.This is sometimes called a pairs trade,and it helps investors gain a foothold in volatile industries or find companies in sectors that have some kind of systematic risk.

Expansion

Hedging has grown to encompass all areas of finance and business.For example,a corporation may choose to build a factory in another country that it exports its product to in order to hedge against currency risk.An investor can hedge their long position with put options,or a short seller can hedge a position though call options.Futures contracts and other derivatives can be hedged with synthetic instruments.

Basically,every investment has some form of a hedge.Besides protecting an investor from various types of risk,it is believed that hedging makes the market run more efficiently.

One clear example of this is when an investor purchases put options on a stock to minimize downside risk.Suppose that an investor has 100 shares in a company and that the company's stock has made a strong move from$25 to$50 over the past year.The investor still likes the stock and its prospects looking forward but is concerned about the correction that could accompany such a strong move.

Instead of selling the shares,the investor can buy a single put option,which gives them the right to sell 100 shares of the company at the exercise price before the expiry date.If the investor buys the put option with an exercise price of$50 and an expiry day three months in the future,they will be able to guarantee a sale price of$50 no matter what happens to the stock over the next three months.The investor simply pays the option premium,which essentially provides some insurance from downside risk.

The Bottom Line

Hedging is often unfairly confused with hedge funds.Hedging,whether in your portfolio,your business or anywhere else,is about decreasing or transferring risk.Hedging is a valid strategy that can help protect your portfolio,home and business from uncertainty.

As with any risk/reward tradeoff,hedging results in lower returns than if you"bet the farm"on a volatile investment,but it also lowers the risk of losing your shirt.Many hedge funds,by contrast,take on the risk that people want to transfer away.By taking on this additional risk,they hope to benefit from the accompanying rewards.

What is a Hedge

A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security.

Hedge

BREAKING DOWN Hedge

Hedging is analogous to taking out an insurance policy. If you own a home in a flood-prone area, you will want to protect that asset from the risk of flooding – to hedge it, in other words – by taking out flood insurance. In this example, you cannot prevent a flood, but you can work ahead of time to mitigate the dangers if and when a flood occurs. There is a risk-reward tradeoff inherent in hedging; while it reduces potential risk, it also chips away at potential gains. Put simply, hedging isn't free. In the case of the flood insurance policy example, the monthly payments add up, and if the flood never comes, the policy holder receives no payout. Still, most people would choose to take that predictable, circumscribed loss rather than suddenly lose the roof over their head.

In the investment world, hedging works in the same way. Investors and money managers use hedging practices to reduce and control their exposure to risks. In order to appropriately hedge in the investment world, one must use various instruments in a strategic fashion to offset the risk of adverse price movements in the market. The best way to do this is to make another investment in a targeted and controlled way. Of course, the parallels with the insurance example above are limited: in the case of flood insurance, the policy holder would be completely compensated for her loss, perhaps less a deductible. In the investment space, hedging is both more complex and an imperfect science.

A perfect hedge is one that eliminates all risk in a position or portfolio. In other words, the hedge is 100% inversely correlated to the vulnerable asset. This is more an ideal than a reality on the ground, and even the hypothetical perfect hedge is not without cost. Basis risk refers to the risk that an asset and a hedge will not move in opposite directions as expected; "basis" refers to the discrepancy.

How Does Hedging Work?

The most common way of hedging in the investment world is through derivatives. Derivatives are securities that move in correspondence to one or more underlying assets. They include options, swaps, futures and forward contracts. The underlying assets can be stocks, bonds, commodities, currencies, indices or interest rates. Derivatives can be effective hedges against their underlying assets, since the relationship between the two is more or less clearly defined. It’s possible to use derivatives to set up a trading strategy in which a loss for one investment is mitigated or offset by a gain in a comparable derivative.

For example, if Morty buys 100 shares of Stock plc (STOCK) at $10 per share, he might hedge his investment by taking out a $5 American put option with a strike price of $8 expiring in one year. This option gives Morty the right to sell 100 shares of STOCK for $8 any time in the next year. If one year later STOCK is trading at $12, Morty will not exercise the option and will be out $5. He's unlikely to fret, though, since his unrealized gain is $200 ($195 including the price of the put). If STOCK is trading at $0, on the other hand, Morty will exercise the option and sell his shares for $8, for a loss of $200 ($205 including the price of the put). Without the option, he stood to lose his entire investment.

The effectiveness of a derivative hedge is expressed in terms of delta, sometimes called the "hedge ratio." Delta is the amount the price of a derivative moves per $1 movement in the price of the underlying asset.

Fortunately, the various kinds of options and futures contracts allow investors to hedge against most any investment, including those involving stocks, interest rates, currencies, commodities, and more.

The specific hedging strategy, as well as the pricing of hedging instruments, is likely to depend upon the downside risk of the underlying security against which the investor would like to hedge. Generally, the greater the downside risk, the greater the hedge. Downside risk tends to increase with higher levels of volatility and over time; an option which expires after a longer period and which is linked to a more volatile security will thus be more expensive as a means of hedging. In the STOCK example above, the higher the strike price, the more expensive the option will be, but the more price protection it will offer as well. These variables can be adjusted to create a less expensive option which offers less protection, or a more expensive one which provides greater protection. Still, at a certain point, it becomes inadvisable to purchase additional price protection from the perspective of cost effectiveness.

Hedging Through Diversification

Using derivatives to hedge an investment enables for precise calculations of risk, but requires a measure of sophistication and often quite a bit of capital. Derivatives are not the only way to hedge, however. Strategically diversifying a portfolio to reduce certain risks can also be considered a hedge, albeit a somewhat crude one. For example, Rachel might invest in a luxury goods company with rising margins. She might worry, though, that a recession could wipe out the market for conspicuous consumption. One way to combat that would be to buy tobacco stocks or utilities, which tend to weather recessions well and pay hefty dividends.

This strategy has its tradeoffs: If wages are high and jobs are plentiful, the luxury goods maker might thrive, but few investors would be attracted to boring counter-cyclical stocks, which might fall as capital flows to more exciting places. It also has its risks: There is no guarantee that the luxury goods stock and the hedge will move in opposite directions. They could both drop due to one catastrophic event, as happened during the financial crisis, or for unrelated reasons, such as floods in China which drive tobacco prices up, while a strike in Mexico does the same to silver.

Spread Hedging
In the index space, moderate price declines are quite common, and they are also highly unpredictable. Investors focusing in this area may be more concerned with moderate declines than with more severe ones. In these cases, a bear put spread is a common hedging strategy.

In this type of spread, the index investor buys a put which has a higher strike price. Next, he sells a put with a lower price but the same expiration date. Depending upon the way that the index behaves, the investor thus has a degree of price protection equal to the difference between the two strike prices. While this is likely to be a moderate amount of protection, it is often sufficient to cover a brief downturn in the index.

Risks of Hedging

Hedging is a technique utilized to reduce risk, but it’s important to keep in mind that nearly every hedging practice will have its own downsides. First, as indicated above, hedging is imperfect and is not a guarantee of future success, nor does it ensure that any losses will be mitigated. Rather, investors should think of hedging in terms of pros and cons. Do the benefits of a particular strategy outweigh the added expense it requires? Because hedging will rarely if ever result in an investor making money, it’s worth remembering that a successful hedge is one that only prevents losses.

Hedging and the Everyday Investor

For most investors, hedging will never come into play in their financial activities. Many investors are unlikely to trade a derivative contract at any point. Part of the reason for this is that investors with a long-term strategy, such as those individuals saving for retirement, tend to ignore the day-to-day fluctuations of a given security. In these cases, short-term fluctuations are not critical because an investment will likely grow with the overall market.

For investors who fall into the buy-and-hold category, there may seem to be little to no reason to learn about hedging at all. Still, because large companies and investment funds tend to engage in hedging practices on a regular basis, and because these investors might follow or even be involved with these larger financial entities, it’s useful to have an understanding of what hedging entails so as to better be able to track and comprehend the actions of these larger players.

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