Most individual investors make very simple decisions when investing - they either buy or sell a stock based on its perceived value. By contrast, professional investors formulate broad investment ideas and then design specific strategies to maximize profit and minimize risk. Individual investors can employ these same strategies by adhering to a simple set of rules and guidelines.

An Introduction to Hedging
Hedges are designed to mitigate risk and isolate opportunity in an investment thesis. For example, an investor who is bullish on a retailer due to its real estate's value, but bearish on the retail sector as a whole, may want to hedge out the risk of a decline in retailers overall and isolate the real estate portfolio's opportunity. Or perhaps an investor wants to buy a stock ahead of earnings, but would like to minimize losses in the event of a dramatic decline. (For more, see Hedging In Layman's Terms.)

Let's take a closer look at the first example. A hedge fund believes that the value of a retailer's real estate assets is not reflected in the share price. However, the hedge fund isn't certain that the retail sector will recover yet amid a declining economy. As a result, the hedge fund decides to take a long position in the retailer, but establish a short position in an ETF that tracks the retail sector.

Assuming that the retailer is trading at $50 per share and the retail ETF is trading at $100 per share, the hedge fund decides to purchase 1,000 shares of the retailer while simultaneously shorting 500 shares of the retail ETF as a hedge. This way, any percentage decline in the retailer relative to the sector is offset dollar-for-dollar.

The result is a position whereby the hedge fund gains from any improvement in the retailer versus its sector, but doesn't stand to lose anything from further declines in the overall retail sector. Meanwhile, the hedge fund can also adjust the position over time as sentiment about the sector or the opportunity changes. (To learn more, read Exchange-Traded Funds: ETF Investment Strategies.)

The Building Blocks of a Hedge
Hedges can be designed using a variety of different types of securities, ranging from options to futures. All that really matters is the hedge's value and its relation to the underlying position, which combine to form the investment strategy. However, there are many types of securities that are very useful for individuals to keep in mind when devising creative hedges:

  • Exchange Traded Funds (ETFs) - These funds provide investors with a convenient hedge against a given sector or natural resource. For example, the retail investment idea above involves short selling a retail ETF to hedge against an overall decline in the sector.
  • Competing Companies - Competing companies within the same or opposite industry can provide a useful hedge in some cases. For example, owning call options in a basket of issuers could help lower the risk of an isolated decline in a volatile credit card issuer.
  • Stock Options - Purchasing call or put options can also help mitigate risk or isolate opportunity in many situations. For example, purchasing a put option in conjunction with a long stock position can help limit downside by owning a right to sell at a known price.
  • Commodities - Certain commodities can also provide useful hedges in many situations. For example, gold is seen by many as a hedge against inflation and can be useful when trying to remove the impact of inflation or currency movements. (To learn more, check out Hedge Inflation With Gold ETFs.)

These various securities can be employed in a number of different ways to hedge against:

  • Sector/Market Risk - Isolating one opportunity in a given sector often involves taking an opposing position in the sector's ETFs or a basket of competing stocks. For example, in the retail situation above, the hedge fund shorted the retail ETF, while being long on the retailer.
  • Sudden Drop Risk - Hedging against upcoming volatile events, such as an uncertain FDA decision, often involves purchasing put options in the same stock to go alongside a long position - a cheap insurance policy that gives investors a guaranteed selling price.
  • Sideways Movement Risk - Investors can even hedge against a lack of movement by writing call or put options against their existing stock position, which provides them with a return on investment while the stock is sideways in exchange for a known selling price. (Learn more in Finding Value In A Sideways Market.)

How to Design Hedges
The actual design of a hedging strategy boils down to a simple, three-step process:

  1. Identify Suitable Securities
    A good hedge often uses the cheapest possible security that offers the protection needed. For example, in the retail situation above, using put options on the retail ETF may be cheaper than purchasing a full short position, while offering the same benefits as the more expensive alternative.
  2. Check the Correlation
    Correlation is very important to consider, as any variance equates to additional unmitigated risk. For example, using gold as an inflation hedge may be less correlated to inflation than using a TIPS ETF or other similar securities. After all, any movement in gold that's not tied to inflation could mean additional downside.
  3. Determine the Value
    A hedge's total value must always match the value of the underlying position in order to completely isolate an investment idea. Going back to our retail example, the total value of the retail ETF short position matched that of the long position in the retailer in order to completely offset any decline in the retail sector. However, the positions can be adjusted as needed, depending on situation and sentiment.

Important Considerations

  • When using options, be mindful of the time frame for the hedge, as options expire.
  • Always try and use baskets of stocks or ETFs as a sector or market hedge, instead of individual stocks that can present their own isolated risks.
  • Be mindful of the cost of commission when hedging - sometimes it can be too costly.
  • Double check correlation or inverse correlation to gauge the strength of the hedge.

Effective hedging strategies can help individual investors mitigate risk and isolate opportunity in much the same way that professional investors protect their investments. However, it is important to double-check these hedges and think through the strategy in order to ensure that they will function as expected and help enhance returns in your portfolio. (For more ideas, read Practical And Affordable Hedging Strategies.)

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