Hedging

Hedging is reducing risk by taking a position that tends to gain when another position loses. It works like insurance: you accept a cost or give up some potential profit in exchange for protection against a bad outcome. A hedge is not meant to make money on its own. Its job is to make the combined result less painful when things go wrong.

Hedging vs speculation#

Both need each other. Hedgers transfer risk; speculators accept it in return for a potential reward and supply the liquidity hedgers need.

Common ways to hedge#

Buying put options#

If you own shares, buying a Protective Put gives you the right to sell at the strike price, capping your downside for the cost of the premium.

Selling futures#

A portfolio manager holding $1 million of large US stocks can sell S&P 500 index futures to offset market risk without selling the stocks. A farmer can sell crop futures to lock in a price. See What Is a Future?.

Collars#

Buying a put and selling a call on the same shares can make protection cheap or free, in exchange for capping the upside. See Collars.

Offsetting correlated positions#

Pairs of assets that usually move together can hedge each other. A trader long one bank stock might short another, or short a bank sector ETF, to remove the risk of the whole sector falling while keeping a view on the individual company. See Pairs Trading.

Currency hedging#

An investor buying foreign stocks is exposed to the foreign currency. Forward contracts or currency futures can remove that risk so returns reflect only the stocks. See FX Forwards and Forward Points.

The hedge ratio#

A hedge rarely needs to cover 100% of a position, and assets do not always move one for one. The hedge ratio is the size of the hedge relative to the exposure. For a stock portfolio hedged with index futures, traders often use beta: a portfolio with a beta of 1.2 needs about 1.2 times its value in index futures to offset typical market moves. See Alpha and Beta.

The costs and limits of hedging#

• Direct costs: option premiums, commissions and spreads.
• Opportunity cost: many hedges reduce gains when the market goes your way.
• Basis risk: the hedge may not move exactly opposite to your position. A tech heavy portfolio hedged with a broad index can still lose if tech underperforms.
• Over hedging: a hedge larger than the exposure becomes a speculative bet in the other direction.
• Timing: hedges expire or need rolling, and protection bought after a fall is more expensive.

Frequently asked questions#

Does hedging eliminate risk?#

No. It reduces or reshapes specific risks, usually at a cost. Some risk always remains, including the chance the hedge does not work as expected.

Is hedging only for big investors?#

No. Individuals can hedge with protective puts, inverse ETFs or by reducing position sizes, although costs and minimum sizes matter more for small accounts.

What is a perfect hedge?#

A position that moves exactly opposite to the original exposure, removing all of its risk. In practice, perfect hedges are rare because instruments rarely match exactly.

Sources#

• Wikipedia, Hedge (finance)