De-Hedge

What Is De-Hedging?

De-hedging refers to the process of closing out positions that were originally put in place to act as a hedge in a trade or portfolio. A hedge is a risk-reducing position taken to limit the potential losses in an existing position or investment.

The de-hedging process may occur all at once, where the full hedge is removed in a single trade; or incrementally, leaving the position partially hedged.

How De-Hedging Works

De-hedging involves going back into the market and closing out hedged positions, which were taken to limit an investor's risk of price fluctuations in relation to the underlying asset.

Removing a hedge against a decline in the market, for instance, may be done when holders of an underlying asset have a strong bullish outlook on their investment. Therefore, investors would prefer to de-hedge those positions to gain full exposure to the expected upward price fluctuations of their investment.

For example, a hedged investor in gold who feels the price of their asset is about to go up would buy back any gold futures contracts they had sold in the futures market. By doing this, the investor will have positioned themself to reap the rewards of an increase in the price of gold if their bullish prediction on gold is correct.

De-hedging may also be done if the hedge itself has paid off. For instance, if the original hedger did experience a substantial decline in price, they may want to remove the successful hedge, allowing the underlying asset to recover from its lows, or take off the position entirely.

De-Hedge vs. 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.

There is a risk-reward tradeoff inherent in hedging: while it reduces potential risk, it also chips away at potential gains.

Derivatives are securities that move in response to 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.

Using derivatives to hedge an investment enables more precise calculations of risk, but requires a measure of sophistication and often quite a bit of capital. Derivatives aren't the only way to hedge. Strategically diversifying a portfolio to reduce certain risks can also be considered a crude hedge.

Why Investors Hedge and De-Hedge

Portfolio managers, individual investors, and corporations, among others, use hedging techniques to reduce their exposure to various risks. In financial markets, however, hedging becomes more complicated than simply paying an insurance company a fee every year.

Hedging against investment risk means strategically using instruments in the market to offset the risk of adverse price movements. In other words, investors hedge one investment by making another.

The goal of hedging is not to make money but 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't be avoided. This is the price paid to mitigate uncertainty.

Example of De-Hedging

Hedge Fund ABC believes the price of oil in three months will increase from $5 a barrel to $8 a barrel. It decides to purchase oil futures contracts today to sell in the future and make a profit. It purchases 100 oil futures contracts for $500.

At the same time, ABC's research shows that because there is current unrest in the Middle East that may become worse in the near term, which would cause the price of oil to fall, it decides to hedge its position by buying 20 oil futures contracts for $100. If the price does indeed go to $8 in three months then ABC will have made a profit of $300 on its primary position but it will also have lost $60 on its shorts, for a total profit of $240.

However, a month after making all its trades, a peace agreement is signed in the Middle East, alleviating any fears of a drop in oil prices, so ABC decides to de-hedge by removing its short position. By then the price of oil had gone up to $6, so the loss was only $20.