Hiob from GettyImages Signature; Canva
What Is a Hedge?
Successful investing is often a balance between risk and reward. While many investors believe that the greater risks they take, the greater rewards they will receive; careless risk taking is certain to result in losses. One way investors can manage or even control the number of risks they are taking is through a hedge, or an offsetting position, such as a derivative security.
How Does Hedging Work?
Hedging works by minimizing potential losses in an asset you have already invested in by building an inverse position in case the asset moves in the opposite direction. Hedging is most commonly performed with derivatives, like options and futures, as well as with short selling.
The trade-off for lessening an investment’s risks, however, is that hedging also lowers the potential for reward, simply because there is a cost involved in the hedge itself. But a lot of investors believe the peace of mind it provides is worth it—especially during periods of market volatility.
The trade-off for lessening an investment’s risks, however, is that hedging also lowers the potential for reward, simply because there is a cost involved in the hedge itself
What Are Some Examples of Hedges in Finance?
Put Options: Say you are an investor with a portfolio of stocks. You are fearing a near-term market correction, yet you believe in your stocks’ long-term potential—or you don’t want to incur tax obligations by selling—so, instead of selling shares, you buy put options on a share-for-share basis on the same stock. This is meant to protect your investment from additional losses below your strike price. Futures: Traders of futures enter agreements to buy commodities for a certain price at a set date in the future. They could hedge this position by buying an additional, opposite position on the futures market; their profit or loss would be settled with the spot price. Long/Short Equity technique: A stock investor who believes that a company’s shares will rise over the long term could buy a position in a company while also short-selling an equal value of shares from a competing company.VIX: The VIX, or volatility indicator, can also be used as a hedging technique. This index measures S&P 500 index options and is used as an overall benchmark for stock market turbulence; generally, levels above 30 are very volatile. Investors can simply purchase shares of an exchange-traded fund (ETF) that tracks the VIX as a volatility play.
What Are Some Key Hedging Terms?
In order to fully understand the concept of hedging, it’s important to become familiar with the concepts that surround it.
Perfect Hedge
A perfect hedge would offset 100% of the risk involved in an investment. However, this is usually impossible to find given that the investments would have to be exactly opposite.
Basis Risk
Since we live in an imperfect world, we’re left with imperfect hedging, and so investors usually uncover hedges that provide partial coverage of market risks to limit their losses. Basis risk, therefore, is what happens if a hedging asset, known as the basis, fails to do what you are expecting it to in terms of offsetting your position. One example of this would be with futures contracts: There could be a mismatch in prices between your contracted price and the actual value at the time its contract becomes due.
Correlation
Correlation, or the measure of the change in value between two securities, is another important factor to know when it comes to hedging. The correlation coefficient ranges from -1 to 1. A number at or close to -1 indicates that the two assets have an inverse relationship, so an investor might choose a strategy in which the correlation between two assets is as close to -1 as possible in order to perform the hedge. This might include buying put options on a stock.
Delta (Hedge Ratio)
Delta measures the change in price of a derivative given a $1 change in price in its underlying asset. Thus, delta is often used to illustrate how effective a hedge is. For these reasons it’s also known as the hedge ratio.
What Are Some Risks Associated with Hedging?
There are many risks involved with hedging. As mentioned above, it’s an imperfect science because investors are using two completely different assets to offset one another. Also, unlike stock picking, where a total loss would only amount to 100% of your investment, short selling and trading derivatives requires a margin account, or the use of borrowed funds that require interest payments. Therefore, an investor may lose exponentially more than the value of their initial investment.
Hedging is not a strategy for beginners—it requires knowledge of advanced trading techniques, such as options. It always pays to do your homework, but especially so with hedging, because if you don’t understand your hedging instrument, your hedge will not be successful.
Also, there is an additional cost involved with taking another position, whether it’s a buying a futures contract, investing in an ETF indexed to the VIX, or buying options.
Hedging is most often used by active traders who are seeking profits from short-term inequities—not buy-and-hold investors. Therefore, it might make more sense for a long-term investor to practice portfolio diversification, which is the practice of spreading wealth across a variety of assets and sectors in order, and to keep their eyes firmly focused on future appreciation.
What Is a Hedge Fund? Who Do They Borrow From?
Hedge funds use a variety of strategies to generate profits for high-net-worth investors. These could include derivatives like options, futures and short selling, as well as using leverage, or borrowed funds from a third-party lender in order to buy more of an asset with profit potential.
Hedge fees are steep—management fees are up to 2% of the NAV, and “performance fees” range as high as 20% of gains. In addition, they do not receive as much scrutiny from the Securities & Exchange Commission as other actively managed funds, like mutual funds, and as such provide investors little downside protection.
And, unless you’re a millionaire, hedge funds are probably not for you since they are only open to qualified investors who typically have anet worth of at least $1 million.
