A Beginner’s Guide to Hedging in Stock Market
In this latest blog post of The Wealth Generating we are explaining all about a Beginner’s Guide to Hedging.
What Is Hedging for Beginners?
The best way to understand hedging is to think of it as a form of insurance. When people decide to hedge, they are insuring themselves against a negative event’s impact on their finances. This doesn’t prevent all negative events from happening, but something does happen and you’re properly hedged, the impact of the event is reduced.
In practice, hedging occurs almost everywhere, and we see it every day. For example, if you buy homeowner’s insurance, you are hedging yourself against fires, break-ins, or other unforeseen disasters.
Portfolio managers, individual investors, and corporations use hedging techniques to reduce their exposure to various risks. In financial markets, however, hedging is not as simple as paying an insurance company a fee every year for coverage.
Hedging against investment risk means strategically using financial instruments or market strategies to offset the risk of any adverse price movements. Put another way, investors hedge one investment by making a trade-in another.
Technically, to hedge you would trade make offsetting trades in securities with negative correlations. Of course, nothing in this world is free, so you still have to pay for this type of insurance in one form or another.
For instance, if you are long shares of XYZ corporation, you can buy a put option to protect you from large downside moves—but the option will cost you since you have to pay its premium.
A reduction in risk, therefore, will always mean a reduction in potential profits. So, hedging, for the most part, is a technique not by which you will make money but by which you can reduce potential loss. If the investment you are hedging against makes money, you have typically reduced your potential profit, but if the investment loses money, your hedge, if successful, reduces that loss.
Understanding Hedging for Beginners
Hedging techniques generally involve the use of financial instruments known as derivatives, the two most common of which are options and futures. Keep in mind that with these instruments, you can develop trading strategies where a loss in one investment is offset by a gain in a derivative.
Say you own shares of Cory’s Tequila Corporation (ticker: CTC). Although you believe in this company in the long run, you are a little worried about some short-term losses in the tequila industry. To protect yourself from a fall in CTC, you can buy a put option (a derivative) on the company, which gives you the right to sell CTC at a specific price (strike price). This strategy is known as a married put. If your stock price tumbles below the strike price, these losses will be offset by gains in the put option.
The other classic hedging example involves a company that depends on a certain commodity. Let’s say Cory’s Tequila Corporation is worried about the volatility in the price of agave, the plant used to make tequila. The company would be in deep trouble if the price of agave were to skyrocket, which would severely eat into their profits.
To protect (i.e. hedge) against the uncertainty of agave prices, CTC can enter into a futures contract (or its less-regulated cousin, the forward contract), which allows the company to buy the agave at a specific price at a set date in the future. Now, CTC can budget without worrying about the fluctuating commodity.
If the agave skyrockets above the price specified by the futures contract, the hedge will have paid off because CTC will save money by paying the lower price. However, if the price goes down, CTC is still obligated to pay the price in the contract and would have been better off not hedging.
Because there are so many different types of options and futures contracts, an investor can hedge against nearly anything, including a stock, commodity price, interest rate, or currency. Investors can even hedge against the weather.
Hedging is not the same as speculating, which involves assuming more investment risks to earn profits.
Disadvantages of Hedging
Every hedge has a cost, so before you decide to use hedging, you must ask yourself if the benefits received from it justify the expense. Remember, the goal of hedging isn’t to make money but to protect from losses. The cost of the hedge, whether it is the cost of an option or lost profits from being on the wrong side of a futures contract, cannot be avoided. This is the price you pay to avoid uncertainty.
While it’s tempting to compare hedging to insurance, insurance is far more precise. With insurance, you are completely compensated for your loss (usually minus a deductible). Hedging a portfolio isn’t a perfect science and things can go wrong. Although risk managers are always aiming for the perfect hedge, it is difficult to achieve in practice.