Hedging is an investment strategy that is simple in concept but that can be difficult in execution. The primary uses of hedging strategies are to either lock in a profit or to protect against a decline. But how is hedging actually accomplished, and is it something that the average investor should know how to do? Read on to learn the basics of hedging, including what the potential benefits and risks are.
Basics of Hedging
If you’ve heard the expression “hedging your bets” before, you understand at least partially what hedging is all about. When it comes to your investments, “hedging your bets” means taking a position opposite to the one that you already have. For example, if you were previously betting that Apple stock would go up, a bet that Apple would instead go down is a hedge against your original position. It might seem counterintuitive that you would make an investment that essentially bets against your existing position, but there are at least two common scenarios in which investors commonly hedge.
Why Would People Hedge? To Lock in Profits
Imagine this scenario: You’ve owned Apple stock, one of your all-time favorites, for 10 years. You have a huge gain in the stock but are worried that it has gained so much over the past few months, thinking that it might start giving some of your profits back. But at the same time, you don’t want to actually sell the stock since you still have a positive long-term outlook on the company and you don’t want to have to pay taxes on your profits. In this case, hedging against your Apple position might make a lot of sense.
You can accomplish a hedge against your Apple position in this scenario in a few different ways. One of the most common is to use options. Here are some examples of this and another method.
Example: Buying a Put Option
Options can be complicated — and risky — investments, and it’s important to understand how they work. But when used as a hedge, much of the risk goes away.
If you are long Apple stock — meaning you own shares — and you want to hedge your existing position, you’ll simply buy a “put” option against Apple. A put option profits when a stock’s price falls. So if you buy a put option on Apple while still owning the stock, your positions will move in opposite directions.
If you’re right and the stock price of Apple falls, while you’ll lose money on the stock position, you’ll earn a profit on the put option. Depending on how you structure the trade, your gains and losses may completely offset each other. This would completely lock in the profit you have in your portfolio, even if your Apple stock loses value.
Of course, the opposite is also true — if you are wrong and Apple stock actually moves up in value, the losses on your put option will offset some of all of your gains.
Another Example: Shorting a Stock
Another way to hedge against a long stock position is to take a comparable “short” position in a stock. Shorting a stock is a bit more complicated than simply buying a put option, but the net effect is similar. To short a stock, you must borrow shares from your broker and then sell them at the current market price. The idea is that if the share price falls, you can buy them back at a lower price, pocketing the gain between your sale price and your purchase price.
In the above scenario, if you are long 100 shares of Apple and want to lock in your profit, you can short 100 shares to completely offset your position. For every dollar that your long position in Apple falls, your short position will gain by the same amount, perfectly hedging you against losing any of your existing profits in Apple.
Why Else Would People Hedge? To Protect Against Losses
Just like investors can hedge to protect a gain, they can hedge to stave off a loss. The process is the same, just in reverse. In this scenario, imagine that you own a stock — or portfolio — but feel that the macroeconomic environment is deteriorating. Even though you believe in your portfolio for the long haul, a near-term recession could create a bear market, dragging down the price of the majority of stocks, even if they show long-term promise.
In this scenario, rather than liquidating your entire portfolio — which could potentially trigger fees and/or tax consequences — you could simply set up a hedge. The value of your hedge would rise if the value of your portfolio falls, thus protecting you against losses without you having to adjust your portfolio.
Just as if you were locking in profits, you could purchase puts or short stocks to guard against a market decline. Other options strategies may also achieve the same result.
Benefits and Risks of Hedging Your Investments
When done properly, the primary risk in hedging your investments is that you’re giving up potential upside. If you set up a perfectly balanced hedge against your Apple stock position, for example, if the stock doubles, you won’t see any of those gains. The benefit, of course, is that if the value of Apple gets cut in half, you won’t suffer any losses.
Another risk of hedging is that you may have to incur transaction costs. Although many brokers now offer zero-commission options trading, most still charge a per-contract fee. Similarly, if you short stocks, you may have to pay a borrowing fee and/or margin interest.
Business Hedging: To Guarantee a Known Price
Hedging isn’t just for investors. Companies commonly hedge their business costs to avoid any drastic negative impacts on their profits. One of the biggest operating expenses of airlines, for example, is the cost of fuel. Oil prices are notoriously volatile, and it’s in the best interest of airlines to stabilize that price and make it as predictable as possible. Thus, most airlines hedge against movements in the price of oil by using futures contracts to guarantee their right to purchase oil at a given price over a given period of time.
Other businesses might use hedging in a slightly different way, such as a farmer hedging against changes in the price of wheat or corn. Farmers can use futures to guarantee a certain price for their crop at the time they plant it, thus hedging out the risk that the market fails and they deliver an unprofitable crop.