Investing involves the risk of loss. But it is possible to hedge, or reduce, some of the risk of loss.
Here’s what you need to know about hedging stock positions with options and other investments.
What Is a Hedge?
A hedge is an investment that helps limit your financial risk. A hedge works by holding an investment that will move in the opposite direction of your core investment, so that if the core investment declines, the investment hedge will offset or limit the overall loss.
Hedges come in many forms and include using derivatives such as options to limit your risk, as well as less complex assets, like cash. Some investors use short selling to hedge their exposure to certain risks and set up their portfolios to profit in the event of a market decline.
One hedge that most investors use without realizing it is diversification. Holding a diversified portfolio is essentially an admission that you don’t know which investments will perform best, so you hedge that risk by having exposure to multiple areas of the market.
How Hedging Works
Hedging can take on many different forms, but one of the most common ways to hedge involves the use of financial instruments known as derivatives. Derivatives get their value from an underlying asset, such as stocks, commodities or indices such as the S&P 500 Index. By using a derivative tied to the underlying asset you’re looking to hedge, you can directly limit your risk of loss.
Let’s look at a hypothetical example…
Say the 100 shares of Apple stock you recently purchased have done very well, and are currently valued at $185 per share. You’d like to hold the shares, but you’re concerned that the price will go down if you hold them too long.
To hedge, you buy a put option for your shares with a strike price of $160. You pay a premium to retain the right to sell your shares at that price. Two weeks later, Apple has a bad earnings report and the stock price plummets. It hits $160 and you exercise your option to sell the stock at that price.
If the price of the stock had remained the same, or gone up, you would have let the option expire and lost the price you paid for the option.
If you wanted to continue this strategy, you would have to purchase a new option.
Large companies often use derivatives to hedge their exposure to input costs as a way of managing their risk. Of course, there are simpler ways to hedge as well. Some investors hold a portion of their portfolio in cash to protect against a market downturn, while others diversify by asset class or geographic region.
Disadvantages of Hedging
Every hedging strategy has a cost associated with it. So, before you decide to use hedging, you should ask yourself if the potential benefits justify the expense.
Remember, the goal of hedging isn’t to make money; it’s to protect from losses. The cost of the hedge – whether it is the cost of an option, or lost profits from being on the wrong side of a futures contract – can not be avoided.
Should You Consider Hedging Your Investments?
For most long-term investors, hedging is not a strategy you’ll need to pursue. If you’re focused on a long-term goal such as retirement, you don’t need to worry about the day-to-day fluctuations in the markets – and in those cases, hedging could end up doing more harm than good in your portfolio.
For those with more of an active investment philosophy or trading mentality, hedging might make sense as a way to manage your risk, but be sure to understand the costs associated with any hedge.
The bottom line: While hedges are used to manage risk, they come with costs and lower potential returns. For most investors who are working toward long-term goals, hedging won’t be necessary and could actually harm your long-term investment returns.
If you have more questions about hedging, or any investment strategy, you’re welcome to schedule a complimentary consultation with our team of financial advisors using the link below.