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.
- To de-hedge is to remove an existing position that acts as a hedge against a primary position in the market.
- Hedging involves taking an off-setting or loss-limiting position against a primary position in order to reduce risk.
- De-hedging can occur for several reasons including a change in outlook, a hedge that has paid off, removal of the primary position, or to reduce costs related to hedging.
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 his asset is about to go up would buy back any gold futures contracts he had sold in the futures market. By doing this, the investor will have positioned himself to reap the rewards of an increase in the price of gold if his 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.
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.