Anyone that wants to get involved with stocks will likely be aware that it is not a sure fire way to make money – if anything, you’re just as likely to lose money as you are to earn it.
Due to such risks of loss involved with stocks, many people will be looking for ways to reduce it. This is where hedging comes into play.
In short, hedging is a risk management strategy that involves someone either buying or selling a stock which could potentially lower the risk levels of financial loss.
But of course, there’s more to it than this. Our handy guide will help you by exploring what hedging is exactly and how it might work.
Read on to learn more!
So, What Is Hedging?
As we mentioned, hedging is a type of risk management tactic which is used to try to reduce the risk of financial loss by buying and selling.
It’s not actually commonplace to use this strategy though when it comes to individual investors – but if it is used, it will take place after the point of initial investment.
In other words, you would not hedge your position right away at the point of purchasing a stock. The usual tactic here would involve protective “put” strategy.
Example Of Hedging With PPS
Let’s assume for a moment that you wished to purchase 100 shares of stock at 30 bucks a share – and in 3 months time, the price shrinks to $25.
Now let’s assume that you don’t actually want to sell this stock – perhaps because you think the price might soar once again, or maybe for tax purposes – but you want to protect yourself from further financial losses.
You may decide to buy put options on a share by share basis. This will allow you to sell your stock within a specific time period for a specified price.
So, let’s say that you bought the put options sufficient enough to allow for a $20 sale per share. This would mean that you would be protected from any extra losses under $20 within the put time period.
Why Might You Use Hedging?
Generally speaking, the hedging option is a way to reduce losses from your investments if they go in the completely wrong direction.
If you have reason to believe that your stock will go the wrong way in a time frame, you may decide that hedging is a good strategy to use. This could be for the following reasons:
- Tax reasons: Taxable events can be caused by selling your position
- Overconcentration: Having too much exposure to an investment
Aside from independent investors, companies may decide to use the hedging strategy in order to improve their stability and certainty in the future of their costs.
An example of this is in the airline industry, where they purchase oil futures months in advance, so they can deal with their budget and reduce any risk of being stung by the volatile oil prices in the future.
Investments Used In Hedging
There are lots of strategies that would use hedging, but generally speaking – hedging is most used in futures, options and derivatives. In fact, options are probably the most common among hedging strategies for individual investors.
Of course, the other choice may be to sell and enter into another position – but this comes with its own risk. You could lose any potential appreciation and therefore, financial benefits.
Should You Hedge?
For professional investors and some companies, hedging can be a very useful strategy to use which will help them reach their objectives and goals.
This is true more so when it comes to those with the right resources – such as the personnel with the expertise to execute the correct moves.
However, it’s not always the right strategy to use. Indeed, hedging can also impose its own risk, so it’s important that we recognize that.
For individual investors, hedging is not always the right decision to make. This could be for the following reasons:
The fact is that hedging involves very complex and sometimes overly complicated tactics that can be quite detrimental to people who aren’t fully knowledgeable of how they work.
Having said that, even professional investors can be stung by employing the hedging strategy, so it’s not always the best option.
Getting another position or purchasing extra buying options will always involve additional costs – and this still might not be a sure fire protection option.
It’s not always the case that hedging will be effective. If we take the example of the airline for example, they may purchase oil at a much higher price than they would have in the future, which overall loses them money.
Finally, hedging is not always the most suitable option, especially for long term investors. If you purchase stock for example that is exposed to short term loss, but you plan to own it for a long time – hedging costs would not make sense.
Additionally, you may find other options like diversification being the better choice. Of course, this also won’t guarantee you against the risk of loss but it is probably more suitable and more effective for some investors.
Can I Make Money From Hedging?
No, hedging is not a strategy to use if you’re planning to “make money”. It is simply used as a way to reduce any major risk of losses.
Will Hedging Help During A Crash?
At any time, hedging is never a sure thing. However, it might be a good option if you already suspect that your stock will plummet. In reality, getting out before a crash is your best option.
The Bottom Line
Hedging is a risk management strategy and if it is used effectively, it can be very useful – however, it is not without its flaws.