Hedging a stock helps reduce risk by taking an offsetting position. Investors have many ways to hedge their portfolio, including shorting stocks, buying an inverse exchange-traded fund, or using options. While hedging can reduce risk, it comes at a cost.
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What is a stock hedge?
What is a stock hedge?
A stock hedge is an asset or investment used to offset an existing position to reduce risk. Investors use hedges to reduce the risk of a particular stock or their entire portfolio. A hedge usually involves taking the opposite position in a similar investment or using financial derivatives like options to limit the potential impact of an unfavorable price movement in the underlying investment.
Types of Stock Hedges
Types of Stock Hedges
Investors can use many different types of stock hedges to reduce risk. Common stock hedges include:
- Shorting a stock: Many investors will short a similar stock to create an offsetting position as a hedge. For example, if an investor has a large allocation to a particular tech stock they want to hedge, they could short a similar technology stock.
- Short a market index: Investors can hedge their market exposure by shorting an exchange-traded fund (ETF). For example, shorting the popular SPDR S&P 500 ETF (SPY -0.7%) would enable an investor to hedge against a decline in the S&P 500 index.
- Purchase an inverse ETF: Investors who don’t want to use short-selling could purchase an inverse ETF as a market hedge. For example, purchasing the ProShares Short S&P 500 ETF (SH 0.67%) is roughly equivalent to shorting an .
- Using put or call options: Options provide investors with many ways to hedge stocks. For example, they could buy a put option on a stock they own to limit their downside to the put’s strike price plus the option premium. Investors could also sell a call option below a stock’s current price to provide some downside protection.
Definition Icon
Options
Stock options are contracts that give the owner the right -- but not any obligation -- to buy or sell a stock at a certain price by a certain date.
What are some drawbacks of a stock hedge?
What are some drawbacks of a stock hedge?
While stock hedges can be beneficial, they also have some drawbacks. Stock hedges are similar to insurance because they provide investors with downside protection. However, like insurance, stock hedges come with a cost in exchange for risk reduction.
That cost can come in many forms, including an upfront expense, ongoing fees, or reduced return. For example, buying a put option to hedge against a decline in a particular stock costs money. While that insurance premium can pay off if there’s a significant decline, the cost of setting up a series of puts to protect specific stocks can add up.
Shorting also costs money. While a short sale initially brings in cash, investors often must pay a recurring fee to borrow shares. Further, if the underlying stock or index used to hedge increases in value, the short seller would pay more money to close their short position than they initially received.
These costs impact returns in the long run. That’s why most investors limit their hedging to periods when they believe there’s a higher risk of a significant downward move in a stock or market index.
Examples of stock hedges
Examples of stock hedges
An investor has an outsized allocation to Apple (AAPL 0.16%) stock. They’re concerned that the technology giant could miss expectations when it reports earnings next month, potentially causing a meaningful decline in the share price.
They hedge against this risk by purchasing a put option that expires in 60 days. With shares recently around $190 apiece, they buy a single contract (100 shares) at a $190 strike price for $6 per share ($600 total). If shares of Apple decline significantly by expiration (more than $6 per share), the put would gain value, and the investor can sell it for a profit. However, if shares don’t fall by more than the purchase premium, the hedge would lose money and could expire worthless.
A recent retiree wants to hedge some of their market exposure to protect against a major sell-off. They purchase enough ProShares Short S&P 500 ETF shares to cover a meaningful portion of their portfolio. If the stock market gains value, that hedge will eat into their returns because the ETF would lose value, and the investor is paying a relatively high ETF expense ratio of 0.89%. However, if the market meaningfully declines, they can sell the inverse ETF at a profit and use the proceeds to buy the dip in the market.
Matthew DiLallo has positions in Apple. The Motley Fool has positions in and recommends Apple. The Motley Fool has a disclosure policy.
FAQs
What is Hedging in the Stock Market. Hedging is the purchase of one asset with the intention of reducing the risk of loss from another asset. In finance, hedging is a risk management technique that focuses on minimizing and eliminating the risk of uncertainty.
What is a hedging strategy for dummies? ›
The easiest and most powerful way to hedge a portfolio is through diversification. Hedge funds often seek out exotic assets to increase their variety of holdings. It works because asset performance is volatile; no asset consistently beats the market.
Is the Motley Fool stock advisor worth it? ›
Motley Fool Stock Advisor can be a good service for investors wanting stock recommendations, reports, and educational resources. The advisor service has an average stock pick return of 628% and has quadrupled the S&P 500 over the last 21 years, according to Motley Fool's website.
Is the Motley Fool Epic bundle worth it? ›
In conclusion, the Motley Fool Epic Bundle stands out as a versatile and valuable investment service that caters to a wide range of investor needs and preferences.
What is a good example of hedging? ›
Examples of Hedging Strategies
For example, a businessman buys stocks from a hotel, a private hospital, and a chain of malls. If the tourism industry where the hotel operates is impacted by a negative event, the other investments won't be affected because they are not related.
What is hedging for beginners? ›
Hedging is an important financial concept that allows investors and traders to minimize various risk exposures that they face. A hedge is effectively an offsetting or opposite position taken that will gain (lose) in value as the primary position loses (gains) value.
How do you hedge successfully? ›
Here are three common strategies:
- Direct hedging involves opening two opposing positions on a single asset at once. ...
- Pairs trading is another common strategy that also involves taking two positions, but this time it involves two different assets. ...
- Safe haven trading is a third hedging strategy to try.
As a rule, long-term put options with a low strike price provide the best hedging value. This is because their cost per market day can be very low. Although they are initially expensive, they are useful for long-term investments.
What is an example of a perfect hedge? ›
We refer to a “perfect” hedge when there is a 1:1 correlation between the financial and physical markets. Example 1: Assume the price has gone down. On November 1st the spot market prices are $59.3/bbl and in that case (assuming perfect hedge) the December futures contract would be $60.30/bbl.
Has Motley Fool really beaten the market? ›
Does Motley Fool beat the market? Yes, Motley Fool stock picks have historically beat the market significantly. Their Stock Advisor picks have returned over 5x more than the S&P 500 over the past 20 years.
While there are some complaints about customer service responsiveness, their core stock analysis and picks appear sound. For investors seeking actionable stock ideas, Motley Fool is a legitimate low-risk option to consider.
Which is better Zacks or Motley Fool? ›
Zacks is better if you want quantitative analysis and short-term trading ideas. Motley Fool is preferable for fundamental analysis and long-term investing approach.
What are Motley Fool's double down stocks? ›
"Double down buy alerts" from The Motley Fool signal strong confidence in a stock, urging investors to increase their holdings.
Does Motley Fool recommend when to sell? ›
Here at The Motley Fool we stand behind a long-term buy-and-hold strategy across the board for any recommended stock. Additionally, we won't always recommend a sell just because the stock price drops - we prefer to weather market fluctuations and hold stocks in companies that we are confident in for the long term.
How do you hedge a stock? ›
Hedging strategies are designed to reduce the impact of short-term corrections in asset prices. For example, if you wanted to hedge a long stock position, you could buy a put option or establish a collar on that stock. These strategies can often work for single stock positions.
What is a short hedge simple example? ›
Say that a farmer produces corn and wants to lock in today's price, when the seeds are planted. The farmer does not want to risk the price going down between now and the harvest time several months into the future. They can sell futures contracts that expire at or after the harvest month.
What is the difference between hedging and trading? ›
Basically, hedging involves the use of more than one concurrent bet in opposite directions in an attempt to limit the risk of serious investment loss. Meanwhile, arbitrage is the practice of trading a price difference between more than one market for the same good in an attempt to profit from the imbalance.
What are the three types of hedging? ›
At a high level, there are three hedge strategy types that companies deploy:
- Budget hedge to lock in a budget rate.
- Layering hedge to smooth rate impacts.
- Year-over-year (YoY) hedge to protect the prior year's rates (50% is likely achievable)
