Wednesday, 17 July 2024

5 Things Investors Should Know About Hedging

5 Things Investors Should Know About Hedging
04 Feb
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Hedging is an investing strategy that sounds so sophisticated that only professional investors can understand it. But at its core, hedging is a rather straightforward strategy for reducing the risk level of a security or portfolio of securities by making other offsetting investments.

Here’s what hedging is and five things you should know about how hedging works.

What is hedging?

Hedging is an investing strategy that uses the purchase or short sale of one security (“the hedge”) to offset the risk in another investment (“the primary investment”). The hedge usually performs well when the primary investment performs poorly. Conversely, the hedge usually performs poorly when the primary investment performs well. In other words, the hedge and the primary investment are negatively correlated.

A hedging strategy can be used to offset a specific security or a portfolio as a whole. In many cases, the investor may expect to lose most or all of the hedging investment and sees the hedge as simply the cost of reducing risk. The hedge is not meant to always succeed as an investment on its own but should be seen as part of the overall return of the portfolio.

Hedges often function similarly to insurance — which hedges against unfortunate events. You pay a premium every year to protect something with the hope that you don’t need the insurance.

A classic example of a hedging strategy is called a “pairs trade.” In a pairs trade, the investor buys one security and sells short another investment that has similar drivers. The investor is not betting on one security but instead on the widening or narrowing of the spread between the two.

For example, an investor might buy stock in a cheap oil company and short an expensive oil company. Both are exposed to the same driver — the price of oil — so the short hedge neutralizes the risk to the long investment. With all else equal, the investor makes money if the long position rises, if the short position falls, if the long rises more than the short or if the short falls more than the long. As the spread narrows, the investor makes money.

Hedging is also popular in a takeover, when one company offers its own stock for the acquired company’s shares in a fixed ratio. Arbitrageurs race to buy the acquiree’s stock and short the acquirer’s stock at that ratio or at some ratio that provides a certain level of exposure. When the acquisition closes, these investors receive shares in the acquirer that offset their short position.

Getting started with hedging: 5 key things to know

Hedging strategies can be sophisticated ways to reduce risk, and there can be multiple ways to combine securities to achieve that objective. Here are five things to know about hedging.

1. Investors have to know what drives value in their investment

Investors who hedge must know their investments well in order to be able to find an investment that offsets the risk they want to hedge. If high oil prices pose a risk to a company, the investor has to find an investment that thrives when oil prices rise. If low oil prices threaten profits, the investor has to find the offsetting investment. So to hedge effectively, an investor must understand the company well and what factors drive the stock price.

2. Hedging costs money

A hedge costs money to set up, even if it’s only an opportunity cost — that is, capital that could have been invested in something else. In many cases, hedges are a complete loss, and they’re designed that way. In other cases, an investor’s money is tied up in the hedge, even if the hedge doesn’t ultimately lose money.

Hedges often have to be replaced because they’re based on short-term securities, such as derivatives, that have a finite lifetime. That creates an ongoing cost, and if you short to hedge a position, you’ll incur a cost of borrow and margin interest for the short.

3. Options can be used to hedge

Options can be used like insurance to hedge a stock position. A typical example is a married put. With this strategy, the investor buys a put on a stock that’s already in the portfolio. If the stock declines, the put acts like insurance, allowing the investor to recover the loss. If the stock rises, the investor makes money on the stock and the put expires worthless.

If you’re looking to use options, here are a few strategies that can hedge stock positions or other options positions.

4. Hedging doesn’t always work

While hedging sounds like a professional and foolproof strategy, it can fail. In a pairs trade, for example, an investor goes long one security and short another, hoping to profit on the narrowing of the spread between the two. But the expensive stock could become more expensive relative to the cheaper stock, with the spread between the two stocks widening and costing the investor money.

To help protect against such mistakes, it’s vital to know your investments thoroughly.

5. You can hedge almost anything

If there’s a financial element in it, you can hedge against it. Oil, orange juice, interest rates, gold, cryptocurrency — if you find an investment that relies on these inputs or many others, you can hedge the risk out of it.

It’s not unusual to see companies take hedged positions. For example, using the futures market, an oil company might sell 50% of next year’s production to lock in today’s prices. It will sell the other 50% when produced, which may be at higher or lower prices. Firms also hedge against currency risks when costs are in a different currency than revenues. Investors can do the same thing for companies that have these kinds of exposures.

Bottom line

Hedging is a strategy for reducing the risk of an investment or a portfolio, but it’s more sophisticated than most investors need. Hedging also requires more time and attention managing a portfolio because many hedges — including those based on derivatives such as options — have to be monitored, closed or reinitiated.

For this reason, most investors stick with a long-only strategy, which can perform very well without hedges. One favorite strategy is to buy an index fund and continue to hold it over time. (Here’s how to start index investing.)

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

James F. Royal, Ph.D.


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