Most people practice hedging without realizing it. If you have any kind of insurance such as home or auto, you’re practicing hedging. In the case of a loss, the deductible is the amount of your known loss since the insurance company covers the rest.
But how does hedging work in finance?
The hedging concept
Most people put money in an investment, hoping it goes up in value. However, there’s always the chance it can go down in value instead. You can lose all of your hard-earned money. This is where hedging comes into play.
If you want to put money in a high-risk investment with a high potential upside, you have a couple of options. You can put the money in and hope it goes up in value. If it does, great—you make cold hard cash. If it doesn’t, you can lose most or all of your investment.
The second option is to offset the risk by hedging via a pairs trade, a put option, and so on. These products rarely eliminate the risk but can lessen the impact of loss if your high-risk investment plummets in value.
What is hedging in finance?
Hedging in financeis offsetting risk in investing without buying an insurance policy. It’s a risk management strategy that uses a variety of investments to balance out the probability of loss.
Corporations as well as individual investors and portfolio managers use hedging techniques to minimize risk exposure. This involves strategic investments to offset the risk of loss and adverse price movements.
Just like with insurance policies, hedging comes with a price. By using hedging strategies, you give up some potential profits for the chance of walking away with most of your money in case of a bad bet.
Reducing risk is almost always correlated with a reduction in profits. There is no free lunch. If you hedge a risky investment, you will end up with less overall profit if you make money. On the flip side, if you end up with a loss, the hedge will lessen the impact on your finances.
How investment hedging works
When it comes to investment hedging, one common method is to use derivatives such as put options. A put option can help protect your investment in case the stock’s price tumbles dramatically.
You buy the right to sell a certain number of shares at a predetermined price within a time range. You pay a premium per option similar to an insurance premium.
There are different ways you can hedge an investment. You can hedge by investing in a company or an entire industry sector. If you want to invest in a company but want to protect yourself from industry weakness, you can bet on a competitor’s stock price going down. This is done by shorting the competitor stock where you sell it high and hope it falls in value so you can buy low.
There is no perfect hedge that allows you to eliminate risk altogether. Rather, it allows you to limit your risk to a known amount just like with insurance. With insurance, you know that if you get in an accident, you will have to pay the deductible, but the insurance will cover the repairs.
The insurance premiums are the price you pay to reduce your risk. You may never get in a car accident, so you’re out the money you pay for insurance. However, in a case where you need it, you will be thankful it was available to cover the cost of damages to your car.
An example of hedging
Let’s say you want to buy 100 shares of Acme Brick Company (ABC) because you think it will perform well over the next few years. If the cost is $50 per share, you will pay $5,000.
If you think the investment is a little risky because of big leadership changes at ABC, you may decide to hedge your position. You purchase an option contract that allows you to sell the shares at $40 within a certain time frame (let’s say six months). You pay $150 for the contract.
A big leadership shakeup causes the ABC stock price to drop to $30 per share three months later. Your initial investment is now worth only $3,000 for a loss of $2,000. Because of your put options contract, you can sell the shares at $40 for a total of $4,000.
Your final loss is $1,000 plus the $150 you paid for the put options contract. This brings the total to $1,150, which is $850 less than the $2,000 you would have lost otherwise.
How currency hedging works
If you invest in stocks or bonds in a foreign currency, you need to consider the value of the underlying currency in addition to the actual investment. When the value of the currency goes up or down, it affects your overall returns.
If you have a portfolio with a heavy international exposure, negative currency movements can cause the value to plummet even if the underlying stocks are solid. There are different ways to offset risk through currency hedging.
One way to hedge against a currency is to buy an investment that moves in the opposite direction. If the currency falls 10 percent, the hedge gains 10 percent for a zero net effect. Alternatively, if the currency gains 10 percent, the hedge will fall 10 percent, so the impact is neutralized.
When evaluating foreign stock and bond funds, find out of the funds are hedged as part of their mandate (sometimes you can tell by the name of the fund). This will minimize or eliminate the underlying foreign currency risk exposure of the fund.
Make sure the fund has low management fees, since these can eat away at your earnings - with and without hedging.
How to hedge properly
Having a well-diversified portfolio is a good way for most investors to hedge their investment risk. One way to do this is by including bonds or bond funds as part of your strategy.
Bonds tend to move in the opposite direction of stocks. (However, this doesn’t apply to junk bonds, which are very volatile and often times can be unpredictable.)
Another way to diversify a portfolio that contains risky individual stocks is to offset them with more stable ones. For example, if you hold a volatile stock that is highly susceptible to market fluctuations, you can hedge with a stable investment.
Buying shares of stocks that tend to weather recessions well and pay solid dividends can offset the losses from the more volatile investment. Keep in mind that there is no guarantee that one stock will go up while the other goes down.
One common hedging strategy employed by portfolio managers and individual investors to reduce risk and increase returns is portfolio diversification. This includes buying a mix of stocks, bonds, commodities, and other investments that respond differently to market fluctuations.
Most investors will never need to put hedging into practice. It’s unlikely that you’ll trade a derivative contract or exercise a put option to hedge a stock pick. However, having the knowledge will help you understand how investors and companies protect themselves against volatility.
Instead of hedging individual stocks or index funds within your portfolio, consider hiring an advisor to help you balance your risk. A traditional advisor or a robo advisor can help you build a well-diversified portfolio. This can help you hedge your investment risks and ride out the day-to-day market fluctuations.
The bottom line on hedging
Hedging is a common strategy used by companies, portfolio managers, and some individual investors to manage risk.
Risk is an inherent element of investing so it’s important to learn the different risk management strategies employed by professional investors and companies. This will make you a better investor and expand your understanding of the stock market.
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