What Does It Mean to Hedge a Stock?
Stock hedging is a great investment strategy to know about and use when you’re looking to pull off some risky investments. While hedging can’t actually reduce the inherent risks in an investment, it can help mitigate potential losses when done well. Learn how hedging works and consider its advantages and disadvantages before you make your first hedge.
- A stock hedge is an advanced investing strategy.
- It helps mitigate potential risk from investments.
- While it usually puts a floor on losses, it also puts a ceiling on potential gains.
- There are several different hedging strategies you can use, including diversification, arbitrage, average down, and staying in cash.
What Is Hedging?
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Hedging is a risk management strategy for advanced investors that’s meant to help protect their downside in risky investments. You can think of it as a sort of insurance, akin to health insurance or homeowners insurance. In exchange for a price, the stock hedge protects you against substantial financial losses. While hedging stocks does mitigate risk, it also reduces potential rewards.
Very active, short-term traders most commonly use hedging strategies when investing. Since they make trades based on potential volatility or spikes and dips in the market, they stand to benefit the most from a protective ‘insurance policy,’ or hedge. Since long-term traders don’t make frequent trades or worry about short-term volatility, they’re less likely to take the sort of risks that require potential hedges.
While you can hedge just about anything, in the stock world, the following are the most common categories of hedges, with specific subcategories within them:
- Forward contract: In a forward contract, two independent parties agree to buy or sell a security at a pre-determined price on a specific date in the future through a non-standardized agreement.
- Futures contract: Futures contracts are very similar to forward contracts — two parties agree to price, quantity, and date for a transaction, but they do so through a standardized agreement instead.
- Money market: Money market hedges mitigate currency or exchange rate risk by stipulating pricing in advance of a trade.
How to Hedge Your Investments
Y ou can hedge investments in a number of different ways, depending on the type of investment and your overall investing strategy. Most commonly, you hedge a risky investment by investing in one asset to help offset potential losses from another asset. Hedging is most frequently used in derivatives trading like futures and options. Other common areas for hedging include:
- Commodities: These are basic goods like metals, oil, natural gas, wheat, and beef.
- Securities: Stocks and bonds are types of securities, or tradable financial assets.
- Currencies: These are money, specifically the money used for a single nation, like the U.S. dollar or the Japanese yen.
- Interest rates: Lenders use interest rates as a fee for borrowing money for an asset.
- Weather: These are derivatives based on weather patterns and the effects on other assets.
There are lots of ways to hedge investments, and each hedging strategy depends on factors like investment type, level of risk, and time frame.
Example of Hedging
To help you understand how hedging works in practice, consider this example of hedging in the stock market.
You’d like to invest in the biotech sector, but you know it’s a highly volatile and competitive market. To mitigate potential risks, you decide to use a hedging strategy. You purchase a long position on PharmaTech worth $2,000 and a short position on BioPharma Inc. for the same amount of money. Now, should the industry react positively and go up, you’ll make money on your long position, but lose your short in BioPharma Inc. If the reverse happens and the biotech sector goes south, you’ll lose money on your long position, but make money on the short.
In either scenario, the hedge limits your potential losses but also reduces your potential profits. A loss in the upside is always the trade-off for loss mitigation on the downside.
Stock Hedging Strategies
You can apply hedging strategies to just about any investment. However, the most common stock hedging strategies include:
- Diversification: When you diversify your portfolio, you invest in a variety of industries, sectors, and types of securities. This way, if a specific area of the market falters, your entire portfolio won’t suffer.
- Arbitrage: The arbitrage strategy involves purchasing a security in one market and then selling it immediately in another market for a small profit. With this strategy, you’re always incurring small profits, which can help cushion any losses on other investments.
- Average down: In the average down strategy, you wait until the share price of a security you already own drops. Then, you purchase more shares, assuming the price will increase. Once it does, at a certain point, you can sell all of your shares and make a profit overall.
- Staying in cash: This is a very straightforward strategy — just keep some of your money in cash in case you lose money on your investments.
Hedging the stock market has quite a few advantages. If you need a few more reasons to consider adopting a hedging strategy on risky investments, consider these:
- Manage potential loss: The primary benefit of using a hedging strategy is mitigating potential loss with downside protection.
- Make more money long-term: Even though you might reduce your potential upside, you should still make more money overall long-term than you would with substantial losses without hedging.
- Receive a set profit: With hedges that involve long and short positions, you can usually determine exactly how much money you’ll make on either position, helping you effectively plan your finances.
- Stay afloat in challenging markets: With stock hedging, even if the market takes a downturn, you should be somewhat protected.
- Increase liquidity: Since investors diversify and spread their money across the market, the overall market becomes more liquid.
- Save time: Hedging on the stock market helps you save time since you won’t have to constantly monitor your positions for fear of a price spike or drop resulting in a profit loss.
- Protect against price changes: Hedging can help protect against exchange rate losses when trading between currencies.
- Practice strategies with low risk: When you use hedging, you can practice complex options and futures trading strategies with little risk should it go poorly.
Stock market hedging is not without its downsides. Make sure you understand the risks before you start hedging your investments:
- Non-specific: While comparing stock hedging to insurance is useful, it’s not an equivalence. Depending on the type of hedge you perform, you may not totally limit losses or make as much in profit as you anticipated.
- Potential income limitations: Particularly for long and short positions, hedging comes with limited profit potential. You won’t make as much money as you would without a hedge in place.
- No guarantee: Hedging is no guarantee that you’ll be totally protected against downsides or make any upside. You can place a solid hedge and still face some loss.
- Complex: Many hedges are complicated and take practice to master. You may not see positive returns, especially on already complex trades like options contracts, right away.
What Is a Hedge Fund?
Hedge funds are a type of diversified security investors can buy into to help hedge other investments. Hedge funds are similar to mutual funds in structure but differ in how they’re managed. Most hedge funds are privately owned investment funds. Their managers only make a commission if the fund goes up in value. If it loses money, then they don’t receive any payment. This set-up appeals to many investors who hate to pay money to money managers who lose profits.
However, since money managers only make a commission when the fund goes up, it can drive some to make poor decisions with the fund’s money. Since risky hedge fund management played an enormous role in the 2008 financial crisis, the Dodd-Frank Wall Street Reform Act now regulates how hedge funds function to avoid another crisis.
Hedging the stock market is a useful strategy for minimizing potential losses while still making modest returns. However, it’s important you know the best hedging strategy to use before you get started to mitigate your downside and protect your upside.