What is hedging and how does it work?

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You may have heard investors or financial market commentators talk about hedging before. Hedging is a way to reduce your risk by buying other kinds of investments or strategically using cash. While it may sound complex and sophisticated, the concept of hedging is actually fairly simple.

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

What is a hedge?

A hedge is an investment that helps limit your financial risk. A hedge works by holding an investment that will move in a different way from your core investment, so that if the core investment declines, the investment hedge will offset or limit the overall loss.

Hedges come in many forms and include using derivatives such as options to limit your risk, as well as less complex assets such as cash. Some investors use short selling to hedge their exposure to certain risks and set up their portfolios to profit in the event of a market decline.

One hedge that most people use without realizing it is diversification. Holding a diversified portfolio is essentially an admission that you don’t know which investments will perform best, so you hedge that risk by having exposure to many different areas of the market. You own cyclical and non-cyclical stocks, stocks and bonds or other investments that benefit from different economic environments. When one goes up, the other typically declines. If you knew exactly what the future held, there’d be no need to diversify.

How hedging works

One of the most common ways to hedge is by using derivatives, which derive their value from an underlying asset such as stocks, commodities or indexes such as the S&P 500. By using a derivative tied to the underlying asset you’re looking to hedge, you can directly limit your risk of loss. Here’s how it works.

Say you’ve purchased a stock at $100 per share, but are concerned that an upcoming earnings announcement could disappoint investors and send the stock plummeting.

One way to limit your exposure to that potential loss would be to purchase a put option on the stock with a strike price that you’re comfortable with. A put option with a $95 strike price 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 rises or falls:

• If the stock drops to $80 per share, you’ll be able to exercise your option to sell at $95. The hedge protects your stock investment fully in the fall from $95 to $80, so your loss is limited to $5 per share ($100 – $95) plus the cost of the option.
• If the stock increases to $110 per share, you’ll realize the $10 gain from the increase in the stock’s price, 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 as a way of managing their risk. Airlines typically hedge jet fuel costs so they’re not exposed to the day-to-day swings of the spot market, while food companies may hedge prices for key ingredients such as corn or sugar.

Of course, there are simpler ways to hedge as well. 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 hedging

• Risk mitigation – The main benefit of hedging is the ability to manage risk and the investment exposure you have. Derivatives can be used to protect yourself if things don’t go in the direction you expect.
• Limit losses – Hedging allows you to limit your losses to an amount that you’re comfortable with. The cost of the hedge will limit your upside, but you can be sure that your losses won’t balloon in the case of a price decline.
• Price clarity – Companies and even individuals such as farmers use derivatives to eliminate the uncertainty of future commodity prices. By using futures and forward contracts, they can lock in prices for key goods well in advance of their delivery date.

Risks of hedging

• Limited gains – While limiting your losses is one of the key benefits of hedging, it also means it will limit your potential gains. If an investment ends up appreciating and the hedge is unnecessary, you’ll lose the cost of the hedge. 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 comes with a cost, either the direct cost of a derivative contract used to hedge or the cost of lower profits in return for some protection. Be sure to understand all the costs associated with a hedge before moving forward with one.
• Wrong analysis – It’s possible that the investment that you thought was a great hedge isn’t so great after all. Imagine owning airline stocks, but being concerned that higher fuel costs could impact the companies’ profits. You might purchase a basket of energy companies as a hedge, thinking that their higher profits will offset any negative impact felt by the airline industry. But a broad economic downturn could send the price of oil and travel demand plummeting, hurting both industries and making your hedge far from perfect.

Should you consider hedging your investments?

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

For those with more of an active investment philosophy or trading mentality, hedging might make sense as a way to manage your risk. But be sure to understand the costs associated with any hedge and the relationship the hedge has with your investments.

Bottom line

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

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.