Hedging is often considered an advanced investing strategy, but the principles of hedging are fairly simple. With the popularity - and accompanying criticism - of hedge funds, the practice of hedging is becoming more widespread. Despite this, it is still not widely understood.
Most people have, whether they know it or not, engaged in hedging. For example, when you take out insurance to minimize the risk that an injury will erase your income, or you buy life insurance to support your family in the case of your death, this is a hedge.
You pay money in monthly sums for the coverage provided by an insurance company. Although the textbook definition of hedging is an investment taken out to limit the risk of another investment, insurance is an example of a real-world hedge.
Hedging by the Book
Hedging, in the Wall Street sense of the word, is best illustrated by example.
Imagine that you want to invest in the budding industry of bungee cord manufacturing. You know of a company called Plummet that is revolutionizing the materials and designs to make cords that are twice as good as its nearest competitor, Drop, so you think that Plummet's share value will rise over the next month.
Unfortunately, the bungee cord manufacturing industry is always susceptible to sudden changes in regulations and safety standards, meaning it is quite volatile. This is called industry risk. Despite this, you believe in this company and you just want to find a way to reduce the industry risk. In this case, you are going to hedge by going long on Plummet while shorting its competitor, Drop. The value of the shares involved will be $1,000 for each company.
If the industry as a whole goes up, you make a profit on Plummet, but lose on Drop - hopefully for a modest overall gain. If the industry takes a hit, for example if someone dies bungee jumping, you lose money on Plummet but make money on Drop.
Basically, your overall profit, the profit from going long on Plummet, is minimized in favor of less industry risk. This is sometimes called a pairs trade and it helps investors gain a foothold in volatile industries or find companies in sectors that have some kind of systematic risk.
Hedging has grown to encompass all areas of finance and business. For example, a corporation may choose to build a factory in another country that it exports its product to in order to hedge against currency risk. An investor can hedge his or her long position with put options or a short seller can hedge a position though call options. Futures contracts and other derivatives can be hedged with synthetic instruments.
Basically, every investment has some form of a hedge. Besides protecting an investor from various types of risk, it is believed that hedging makes the market run more efficiently.
One clear example of this is when an investor purchases put options on a stock to minimize downside risk. Suppose that an investor has 100 shares in a company and that the company's stock has made a strong move from $25 to $50 over the last year. The investor still likes the stock and its prospects looking forward, but is concerned about the correction that could accompany such a strong move.
Instead of selling the shares, the investor can buy a single put option, which gives him or her the right to sell 100 shares of the company at the exercise price before the expiry date. If the investor buys the put option with an exercise price of $50 and an expiry day three months in the future, he or she will be able to guarantee a sale price of $50 no matter what happens to the stock over the next three months. The investor simply pays the option premium, which essentially provides some insurance from downside risk.
The Bottom Line
Hedging is often unfairly confused with hedge funds. Hedging, whether in your portfolio, your business or anywhere else, is about decreasing or transferring risk. Hedging is a valid strategy that can help protect your portfolio, home and business from uncertainty.
As with any risk/reward tradeoff, hedging results in lower returns than if you "bet the farm" on a volatile investment, but it also lowers the risk of losing your shirt. Many hedge funds, by contrast, take on the risk that people want to transfer away. By taking on this additional risk, they hope to benefit from the accompanying rewards.