Hedge

Loading the player...

What is a 'Hedge'

A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.

BREAKING DOWN 'Hedge'

Hedging is analogous to taking out an insurance policy. If you own a home in a flood-prone area, you will want to protect that asset from the risk of flooding – to hedge it, in other words – by taking out flood insurance. There is a risk-reward tradeoff inherent in hedging; while it reduces potential risk, it also chips away at potential gains. Put simply, hedging isn't free. In the case of the flood insurance policy, the monthly payments add up, and if the flood never comes, the policy holder receives no payout. Still, most people would choose to take that predictable, circumscribed loss rather than suddenly lose the roof over their head.

A perfect hedge is one that eliminates all risk in a position or portfolio. In other words, the hedge is 100% inversely correlated to the vulnerable asset. This is more an ideal than a reality on the ground, and even the hypothetical perfect hedge is not without cost. Basis risk refers to the risk that an asset and a hedge will not move in opposite directions as expected; "basis" refers to the discrepancy.

Hedging Through Derivatives

Derivatives are securities that move in terms of one or more underlying assets; they include options, swaps, futures and forward contracts. The underlying assets can be stocks, bonds, commodities, currencies, indices or interest rates. Derivatives can be effective hedges against their underlying assets, since the relationship between the two is more or less clearly defined.

For example, if Morty buys 100 shares of Stock plc (STOCK) at $10 per share, he might hedge his investment by taking out a $5 American put option with a strike price of $8 expiring in one year. This option gives Morty the right to sell 100 shares of STOCK for $8 any time in the next year. If a year later STOCK is trading at $12, Morty will not exercise the option and will be out $5; he's unlikely to fret, however, since his unrealized gain is $200 ($195 including the price of the put). If STOCK is trading at $0, on the other hand, Morty will exercise the option and sell his shares for $8, for a loss of $200 ($205). Without the option, he stood to lose his entire investment.

The effectiveness of a derivative hedge is expressed in terms of delta, sometimes called the "hedge ratio." Delta is the amount the price of a derivative moves per $1.00 movement in the price of the underlying asset.

Hedging Through Diversification

Using derivatives to hedge an investment enables for precise calculations of risk, but requires a measure of sophistication and often quite a bit of capital. Derivatives are not the only way to hedge, however. Strategically diversifying a portfolio to reduce certain risks can also be considered a—rather crude—hedge. For example, Rachel might invest in a luxury goods company with rising margins. She might worry, though, that a recession could wipe out the market for conspicuous consumption. One way to combat that would be to buy tobacco stocks or utilities, which tend to weather recessions well and pay hefty dividends.

This strategy has its tradeoffs: if wages are high and jobs are plentiful, the luxury goods maker might thrive, but few investors would be attracted to boring counter-cyclical stocks, which might fall as capital flows to more exciting places. It also has its risks: there is no guarantee that the luxury goods stock and the hedge will move in opposite directions. They could both drop due to one catastrophic event, as happened during the financial crisis, or for unrelated reasons: floods in China drive tobacco prices up, while a strike in Mexico does the same to silver.

RELATED TERMS
  1. Short Hedge

    An investment strategy that is focused on mitigating a risk that ...
  2. Delta Hedging

    An options strategy that aims to reduce (hedge) the risk associated ...
  3. Cross Hedge

    The act of hedging ones position by taking an offsetting position ...
  4. Natural Hedge

    A method of reducing financial risk by investing in two different ...
  5. Gamma Hedging

    An options hedging strategy designed to reduce or eliminate the ...
  6. Basis Risk

    The risk that offsetting investments in a hedging strategy will ...
Related Articles
  1. Trading

    What is a Hedge?

    A hedge investment offsets the risk of adverse price movements in another investment.
  2. Investing

    A Beginner's Guide To Hedging

    Hedging is a practice every investor should know about.
  3. Managing Wealth

    Hedging for Beginners: A Guide

    People hedge as insurance against market volatility. Anyone can do it; here's a primer.
  4. ETFs & Mutual Funds

    For Maximum Market Returns, Get Creative With Hedges

    Proper hedges help to contain your losses while still allowing profits to grow.
  5. Managing Wealth

    How To Avoid Exchange Rate Risk

    What are the best strategies to avoid exchange rate risk when trading?
  6. Managing Wealth

    Will Hedge Funds Be Around in 10 Years?

    Learn why some analysts see hedge funds as a dying breed, especially after a torturous January 2016 for fund managers around the world.
  7. Trading

    Practical And Affordable Hedging Strategies

    Learn how to find and use the most cost-effective ways to transfer risk.
  8. Trading

    Hedging With Puts And Calls

    This trading strategy can reduce your risk - but only if you use it effectively.
  9. ETFs & Mutual Funds

    4 Reasons to Still Consider Traditional 2 & 20 Hedge Funds

    Find out why traditional 2 & 20 hedge funds are still worth considering as an investment, even though they have underperformed for the last several years.
  10. ETFs & Mutual Funds

    How To Start a Hedge Fund In the United States

    A general overview of how to start a hedge fund firm in the United States, including complying with state and federal regulations.
RELATED FAQS
  1. What happens if you don't hedge your investments?

    Learn the purpose, advantages and disadvantages of hedging, and find out how to utilize hedging to enhance an overall investment ... Read Answer >>
  2. How do hedge funds use short selling?

    Learn how hedge funds use short selling to profit from stocks that are falling in price. Explore different analytical techniques ... Read Answer >>
  3. Is it possible to be perfectly hedged against risk?

    Learn what it means to mitigate the market risk of a portfolio through hedging and to what extent hedging can reduce downside ... Read Answer >>
  4. If I use hedging as a risk strategy, do I have to keep my eye on my portfolio all ...

    Understand the concept of hedging and learn how this key element to portfolio management can help an investor protect profits ... Read Answer >>
  5. What does a hedge fund do?

    Read how hedge funds differ from other investment vehicles and how their investment strategies make them unique and potentially ... Read Answer >>
  6. Can you invest in hedge funds?

    Read about what it takes to invest in a hedge fund, and learn how some investors find ways to indirectly capture a hedge ... Read Answer >>
Hot Definitions
  1. Sell-Off

    The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
  2. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
  3. Brexit

    The Brexit, an abbreviation of "British exit" that mirrors the term Grexit, refers to the possibility of Britain's withdrawal ...
  4. Underweight

    1. A situation where a portfolio does not hold a sufficient amount of a particular security when compared to the security's ...
  5. Russell 3000 Index

    A market capitalization weighted equity index maintained by the Russell Investment Group that seeks to be a benchmark of ...
  6. Enterprise Value (EV)

    A measure of a company's value, often used as an alternative to straightforward market capitalization. Enterprise value is ...
Trading Center