Hedging is a type of investment that essentially acts as an insurance policy, purchased with the intent to provide protection against the risks associated with another investment.
Investors often hedge to control their exposure to the risk of loss. Hedging methods vary widely depending on what the investor views as the main risks they face. Common hedges include derivatives like options and futures contracts, or investments in commodities like gold or oil, or cryptocurrencies, or fixed-income investments like Treasury bonds.
What Is Hedging?
You can define hedging as an investment made to reduce the risks associated with another investment. Most often, investors will hedge to protect themselves in the event that their investments go down in value and limit potential losses. While there are many ways to hedge, many investors go about hedging with options, purchasing securities that move in the opposite direction of the main investment. Another common hedge is an investment whose price movements historically do not correlate to the main investment.
For investors, protecting a portfolio against downside risk can be as important as generating returns.
How Does Hedging Work?
In many ways, hedging investments work like an insurance policy. A homeowner who has purchased a house in an area that’s at risk from wildfires may purchase insurance to protect their home from fire. That insurance policy costs money, and over time will diminish from the funds the homeowner has when they sell the house. But if there’s a fire, that insurance may protect the homeowner from financial ruin.
Hedging is like that insurance policy. Investors can’t protect against all risks. But with the proper hedges in place – the right insurance policy – they can protect their holdings from certain dangers. But, like insurance, those hedges cost money to make. They also reduce an investor’s exposure to the upside of the other elements of their portfolio.
Pros & Cons of Hedging
In addition to investors, companies that operate with heavy exposure to the prices of certain commodities like oil, or whose business model only works in stable interest-rate environments, use hedges to protect their business. To understand the pros and cons of hedging, consider one such company.
One example might be an airline, whose fuel costs impact the company’s profitability. The airline may have a trading desk whose sole job is to buy and sell options and futures contracts related to crude oil, as a way of protecting the company against the shock of a sudden upturn in oil prices.
The first pro of hedging for the airline is that those financial derivative instruments allow it to project its fuel costs with some degree of certainty at least a few months into the future. The other pro of hedging comes when the price of oil skyrockets for whatever reason. In that case, the airline knows it can buy oil at the previously predetermined price in the oil futures contracts it owns.
The con of hedging would be the constant ongoing expense of maintaining it. The airline has to pay for the oil futures contracts, even if it never exercises them. Futures contracts expire on a regular basis, requiring the company to continue buying them. And if fuel costs don’t go up, then it’s likely that the futures contracts the airline buys will be worthless when they expire.
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The company also has to devote personnel to maintaining the portfolio of its hedges, to buy and sell the derivatives, and to periodically test the hedge to make sure it continues to protect the company as the markets shift. For the airline that represents money and talent that is diverted away from its core business.
The analogy for investors is clear. While hedges can protect an investment plan, they also come with a cost in time and money. And it’s up to each investor to determine whether the cost of a hedge is worth the protection it offers.
Hedging Examples and Strategies
There are several ways that investors can use hedging to protect their portfolios.
Portfolio diversification is probably the best known and most widely used risk management strategy. It relies on a broad mix of investments within a portfolio to protect the portfolio from facing too large of a loss if one investment loses value. A diversified portfolio will hold several distinct asset types to reduce its exposure to any single investment risk. For example, investors may balance out the risk of a stock holdings with bond securities, since bonds tend to perform better in markets where stocks struggle.
Spread hedging is a risk-management strategy employed by options traders. In this strategy, a trader will buy options with two separate strike prices to earn a small return and protect themselves against price movements in the security that underlies the options. In a bull put spread, for example, a trader might purchase one long put with a lower strike price and one short put with a high strike price.
Forward contracts are financial derivatives used mostly by businesses to protect themselves from changes in the value of a currency. For the purchaser, the contract effectively fixes the rate of exchange between two currencies for a period of time. The airline example discussed above is a forward hedge.
Delta hedging is a strategy used by options traders to reduce the directional risk of price movements in the security underlying the options contracts. In the strategy, the trader buys or sells options to offset investment risks and reach a delta neutral state, in which the investment is protected regardless of which way the asset price moves.
Tail Risk Hedging
Tail risk hedging refers to an array of strategies whose goal is to protect against extreme shifts in the markets. The strategies involve a close study of the major risk factors faced by a portfolio, followed by a search for the least expensive investments to protect against the most extreme of those risks. For example, an investor overweight U.S. equities might purchase derivatives based on the Volatility Index, which tends to negatively correlate to the S&P 500 Index.
Binary Options Hedging Strategy
In a binary options hedging strategy, the investor buys both a put and a call on the same underlying security, each with a strike price that makes it possible for both options to be in the money at the same time. Binary options only guarantee a payout if a predetermined event occurs.
A forex hedge refers to any transaction made to protect an investment from changes in currency values. As a hedge, they may be used by investors, traders and businesses. For example, since GBP/USD and EUR/USD typically have a positive correlation, you could hedge a long position in GBP/USD with a short position in EUR/USD.
Another example of forex hedging is purchasing a currency-hedged ETF. Doing so gives investors the protection of a forex hedge against the investments within their ETFs, without having to actually purchase the hedge on their own.
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Hedging for Hyperinflation
Inflation hedges are those investments that have outperformed the market when inflation is a major factor in the economy. While every inflationary period is different, with other global, market and macroeconomic factors in play, investors have historically found shelter – and even growth – during inflation by investing in certain assets.
Some investments that have a reputation as inflation hedges include precious metals such as gold, and commodities like oil, corn, beef, and natural gas. Other inflation hedges include REITS and real estate income.
Some investors view dollar-cost averaging, which involves investing a set amount of money at preset intervals regardless of market performance, as a way to hedge against market volatility. That’s because dollar-cost averaging, by definition, means that you’re buying investments when they’re both high and low — and you don’t have to worry about trying to time the market.
Is Hedging Viable for Retail Investors?
Yes. While some hedging involves complicated options strategies, you can also hedge your portfolio by simply making sure that you have diversified holdings. If you’re investing to protect against certain risks, such as inflation or interest rate increases, that’s also an example of hedging.
Hedges are investments, often derivatives that protect investors from risk. However, it’s possible to hedge some investments without trading options. Building a diversified portfolio of stocks and bonds, for example, or investing in real estate to protect against inflation risk are also examples of hedging.
If you are ready to try your hand at options trading, consider checking out SoFi’s user-friendly options trading platform. Investors can trade options from the mobile app or web platform, and learn more about options-related topics through the educational resources offered.
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Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.