Many people will have heard of hedging and how it is part of investment strategy, but not everyone will understand what it means or how it can be implemented.
If you have invested in stocks, you may be wondering if hedging is something you should be engaged in.
Are there different types of hedging (see also ‘What Is Hedging In Stocks?‘), and how do they work? Does hedging involve any additional costs for you as an investor, and how much does it reduce your exposure to risk? We look at all of these questions and explain how to hedge stocks.
What Is Hedging?
Hedging can be seen as a form of insurance on your stock. It is a means of protecting your investment by taking precautions against risk. This usually means taking the opposite position in a related security, thereby offsetting any potential loss associated with the asset.
However, hedging is not as simple as paying an annual premium for protection against adversity.
Market strategies and financial instruments are used to ensure that if there is a negative price movement, then the impact is reduced on your portfolio.
When you hedge your stock, you are protecting yourself against significant losses if the price drops by using one or more various mechanisms.
This could be purchasing options which shifts the risk onto another party or by short selling stock.
The downside of hedging is that any potential profits will not be as large as you will have used funds to hedge the stock against adverse movement. While hedging can reduce potential losses, it cannot increase gains.
Types Of Hedging
So what are the types of hedging that you can use to protect against adverse price movement on an asset.
Protecting an asset with a simple hedge involves putting a stop loss order (see also ‘How To Set Stop Loss On Webull‘) against your stocks. This means that if the price of the stock falls below a certain level, your broker knows to sell them.
While you will still suffer a loss, you are protected against much larger declines.
A good rule of thumb is to have a diversified portfolio which will automatically spread the risk across different companies, industries and locations. However, it will require a good deal of capital to hedge through diversification.
It is also not guaranteed that stock acquired to hedge a vulnerable asset will thrive and make gains. It may not move in the opposite direction and could fall foul of global events or just be a victim of a financial contraction.
However, in general, diversification is a positive move.
Another way to hedge stocks is to use options. An option is a contract that gives the holder the right but not the obligation to buy or sell an asset at a particular price.
Some options can only be executed on a certain date, while others can be executed anytime before it expires.
The price of a put option is the premium paid, and the way that options work as a hedge against market volatility depends on the strategy employed. These are long put options, collar, fence or covered call, each with their own benefits and risks.
Hedging Stock Without Using Options
Some hedge strategies do not involve options. You can hold cash as a hedge to offset any adverse market conditions, as it is a low risk asset. Although, it will earn little or no interest and its intrinsic value will fall with rising inflation.
Short selling stocks and then buying them back at a lower price can impact on the share price. This is an inexpensive way to hedge stocks against market decline in the short term.
Purchasing products with inverse returns is a way to hedge stocks. ETFs and other securities which appreciate in value when the market declines are often leveraged. They will therefore require less capital to acquire and can be traded in a normal trading account.
Another recent method of hedging is to buy volatility. The VIX index tracks implied volatility for many S&P options. There is a market for futures based on this index and ETFs, as well as options based on these futures.
Cost Of Hedging Stocks
Any hedging strategy will have associated costs. The actual cost of acquiring the security is an obvious cost. But you also have to consider the loss in profits if your stock goes up instead of declining in price.
Hedging with options involves the price of a premium, which depends on several factors, such as the current price and interest rate, the strike price and expected dividends.
The cost may also take into account expected volatility, which is subject to supply and demand.
Matching the vulnerable asset with the right hedging instrument can be very difficult and costly. That is why in most cases the match is less than perfect. However, the peace of mind that comes from hedging can be worth the cost in order to gain long term goals.
Who Is Hedging For?
It is unlikely that individual investors will need to hedge their stocks. Many people are investing in stocks over the long term in order to pay for their retirement, and as such are not watching the market daily or concerned about daily fluctuations in share prices.
Short term declines are not the best reason for an individual investor to set up a hedge, as the cost of the protection will only add to potential losses. Having a long term view means accepting fluctuations over the short term.
A better way to protect long term investments for an individual investor is to have a diversified portfolio which spreads the risk.
Whether hedging is for you or not, as an investor in the market, it is important that you are aware of all the mechanisms and strategies that you can use to protect your portfolio.
Investing your money is always a risk, but there are things you can do to protect yourself.
Understanding hedging strategies will help you become a better investor and safeguard your future.