Hedging is a way to protect profits or limit the losses of one asset by purchasing or selling another.
- Hedging is a strategy to limit losses or protect future prices.
- Hedges move in the opposite direction of the investment they are protecting.
- Hedging can be expensive because in some cases, it requires that you pay premiums.
How Hedging Works
Hedging is a sophisticated risk management strategy. Hedges are similar to insurance. In theory, they can limit potential losses of an asset that you own or limit the price of an asset you want to buy. Typically, if the value of your investment goes down, the value of your hedge goes up. If the value of your investment goes up, the value of the hedge generally goes down, speaking. Options, which are contracts for the right to buy or sell a stock or other asset at a certain price and time, are often used for hedging strategies.
Individual investors usually hedge for two reasons:
- Over-concentration: You own a lot of stock in one company, so you want to protect yourself.
- Tax implications: You can use hedges to delay the sale of a stock or other asset while protecting its value.
Hedging is used by portfolio managers and institutional investors to manage risk. Companies also use hedging to control the price of commodities or currencies they use in their day-to-day business. Farmers and ranchers use hedging to protect the price of their cattle.
Example of Hedging
Suppose the 100 shares of Apple stock you recently purchased have done very well and are sitting at $175. You’d like to hold on to the shares, but you’re concerned that the price will go down if you hold them too much longer.
To hedge, you buy a put option for your shares with a strike price of $160. You pay a premium to retain the right to sell your shares at that price. Two weeks later, Apple has a bad earnings report and the stock price plummets. It hits $160 and you exercise your option to stop the bleeding.
If the price of the stock had stayed the same or gone up, you would have let the option expire and lost whatever you paid for premiums. If you wanted to continue the strategy, you would have to purchase a new put option.
Asset allocation and diversification are used in individual investment plans to manage risk and returns, but they aren’t hedging strategies. Hedging strategies have a direct negative correlation. Stocks and bonds, for example, don’t necessarily move in different directions at the same time and, in fact, may move in the same direction.
Types of Hedging Strategies
Typically, investors create hedges using various types of derivatives such as options, futures, and forwards. Inverse ETFs may also be options for hedging in certain cases, but are risky investments.
Puts give you the right to sell your stock at a specified price for a specified time. You choose the price at which the put sells (strike price), providing you with a secure floor for your stock’s price. Protective puts can limit or eliminate losses. However, they aren’t free; you have to pay a premium for them, so you could lose money if your stock never drops enough to hit the strike price.
Calls give you the right to buy a stock at a specified price for a specified time. If you wanted to hedge your Apple shares, you could sell covered calls. The calls would generate income in the form of premiums the buyer pays you as long as the stock doesn’t hit its strike price. So, if the stock price drops like you’re worried it will, you’ll earn premiums from the covered call. However, if the stock’s price hits the strike price, then your gains are capped at the strike price.
Collars are a combination of protective puts and covered calls. You buy the puts to protect against a drop in stock price and, in theory, your calls generate premiums you can use to pay for your puts.
Using a collar options strategy is a low-cost way to limit potential losses.
What It Means for Individual Investors
Hedges can be expensive in some cases, and price fluctuations are expected over time. Because of that, they aren’t recommended for investors who just want to buy and hold a stock. If you choose to create a hedge, be sure you understand the mechanics of the hedge, including (when applicable) the strike price and how much you’ll pay or earn in premiums.
Frequently Asked Questions (FAQs)
What is hedging in stocks?
Hedging a stock means buying an asset that will move in the opposite direction of the stock. The hedge could be an option, future, or short sale.
How much does hedging cost?
Hedging strategies frequently use options and futures to limit losses. Options and futures have limited lifespans and sell for a premium. Premiums are impacted by the expiration date, price of the stock or other asset, and volatility.
What does portfolio hedging mean?
Investment portfolios usually have a combination of different asset classes, stocks, bonds, real estate, cash, etc. with many individual positions. Portfolio hedging involves protecting some or all of the portfolio from loss. Hedging is usually a short-term strategy. For example, an investor who believes stock prices are headed down could protect the equity portion of the portfolio by using an inverse ETF.