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Definition:
In the investment world, hedging is the practice of offsetting potential losses from one asset with potential gains in another.
🤔 Understanding a hedge
A hedge is an investment, which attempts to offset potential losses from one asset with potential gains in another asset. The idea is to try and ensure that if one investment fails, there is another investment — assumed not to move in tandem with the first investment — to help offset the loss. There are many hedging strategies, and they all revolve around reducing risk. While there are more sophisticated methods of hedging available to some investors, there is no perfect hedge that eliminates risk entirely.
Example
Say you invest a chunk of money in the fictional company Frankie’s Foghorns. You expect the company’s stock price to rise. However, since you’ve invested a lot, you want some backup in case the price goes down instead. To help mitigate the risk of your investment in Frankie’s Foghorns, you buy a put option, giving you the right to sell your stock at the strike price. The put option is your hedge limiting the downside risk of a falling stock price.
Takeaway
You hedge for the same reason you purchase an insurance policy…
When you own a car, you usually purchase an insurance policy to cover losses from potential accidents. If you lose value because the car is totaled, you expect to gain value from the insurance company writing you a check to cover the damage. Similarly, a hedge can counteract losses in the value of an asset.
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Tell me more…
- What kind of investments can be used to hedge?
- What is a hedging instrument?
- What are the risks and rewards of hedging?
- Additional Disclosure:
What kind of investments can be used to hedge?
Generally speaking, it depends. Derivatives, like options and futures contracts, are often used in hedging strategies. These are contracts whose value relies on the underlying security. To create a hedge, you might utilize strategies that seek to gain in value when your main underlying positions lose value.
For example, someone who owns shares of one stock might hedge by buying puts or selling calls in that underlying stock. Someone who owns many stocks (like a portfolio manager) might sell a futures contract that tracks a stock market index like the S&P 500. If the basket of stocks in his portfolio fell, the value of the short futures contract would increase in value, potentially offsetting some of the losses in the stock portfolio.
You can hedge currencies through the exchange rate and foreign exchanges as well, similar to a stock. Just like stock prices fluctuate, currency prices (as they relate to other currencies) fluctuate. The US dollar may be strong against the Japanese yen but weak against the euro at a given time, but that might change later due to economic conditions. Foreign currency hedging can involve using currencies that offset each other’s weaknesses, for example.
What is a hedging instrument?
A hedging instrument is a general term for any financial instrument used to hedge against the potential loss of value in another asset.
What are the risks and rewards of hedging?
For most long-term, passive investors, hedging is a technique that is seldomly used. It requires a greater knowledge of the markets, access to certain financial products, and requires a delicate balance of timing and execution.
For professional investors, hedging risks and rewards vary greatly depending on the type of hedging actions used. Hedging’s purpose lies in offsetting losses with gains elsewhere. The reward of hedging done well is a reduction in risk of loss if not losses themselves. While hedging may be a bit like insurance, hedging isn’t as secure as insurance. There is no perfect hedge — That unicorn simply doesn’t exist in the real world, only in theory. Most hedging strategies come with a cost. Either the initial investment cost itself, an options contract fee also known as a premium, time in managing the hedges, or higher risk.
Additional Disclosure:
Options trading entails significant risk and is not appropriate for all customers. Individuals must read and understand the Characteristics and Risks of Standardized Options before engaging in any options trading strategies. Options transactions are often complex and may involve the potential of losing the entire investment in a relatively short period of time. Robinhood Financial does not guarantee favorable investment outcomes. The information presented is not a recommendation of a security or investment strategy. Supporting documentation for any claims, if applicable, will be furnished upon request.
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Certain limitations apply
New customers need to sign up, get approved, and link their bank account. The cash value of the stock rewards may not be withdrawn for 30 days after the reward is claimed. Stock rewards not claimed within 60 days may expire. See full terms and conditions at rbnhd.co/freestock. Securities trading is offered through Robinhood Financial LLC.
