Although it might sound like something done by your gardening-obsessed neighbor, hedging is a useful practice that every investor should know about. In the markets, hedging is a way to get portfolio protection—and protection is often just as important as portfolio appreciation.

Hedging, however, is often discussed broadly more often than it is explained, making it seem as though it belongs only to the most esoteric financial realms. Even if you are a beginning investor, you can learn what hedging is, how it works, and what techniques investors and companies use to protect themselves.

Key Takeaways

  • Hedging is a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset.
  • The reduction in risk provided by hedging also typically results in a reduction in potential profits.
  • Hedging strategies typically involve derivatives, such as options and futures contracts.

A Beginner's Guide To Hedging

What Is Hedging?

The best way to understand hedging is to think of it as a form of insurance. When people decide to hedge, they are insuring themselves against a negative event's impact to their finances. This doesn't prevent all negative events from happening, but something does happen and you're properly hedged, the impact of the event is reduced.

In practice, hedging occurs almost everywhere, and we see it every day. For example, if you buy homeowner's insurance, you are hedging yourself against fires, break-ins, or other unforeseen disasters.

Portfolio managers, individual investors, and corporations use hedging techniques to reduce their exposure to various risks. In financial markets, however, hedging is not as simple as paying an insurance company a fee every year for coverage.

Hedging against investment risk means strategically using financial instruments or market strategies to offset the risk of any adverse price movements. Put another way, investors hedge one investment by making a trade in another.

Technically, to hedge you would trade make offsetting trades in securities with negative correlations. Of course, nothing in this world is free, so you still have to pay for this type of insurance in one form or another.

For instance, if you are long shares of XYZ corporation, you can buy a put option to protect you from large downside moves—but the option will cost you since you have to pay its premium.

A reduction in risk, therefore, will always mean a reduction in potential profits. So, hedging, for the most part, is a technique not by which you will make money but by which you can reduce potential loss. If the investment you are hedging against makes money, you have typically reduced your potential profit, but if the investment loses money, your hedge, if successful, reduces that loss.

Understanding Hedging

Hedging techniques generally involve the use of financial instruments known as derivatives, the two most common of which are options and futures. Keep in mind that with these instruments, you can develop trading strategies where a loss in one investment is offset by a gain in a derivative.

Say you own shares of Cory's Tequila Corporation (ticker: CTC). Although you believe in this company for the long run, you are a little worried about some short-term losses in the tequila industry. To protect yourself from a fall in CTC, you can buy a put option (a derivative) on the company, which gives you the right to sell CTC at a specific price (strike price). This strategy is known as a married put. If your stock price tumbles below the strike price, these losses will be offset by gains in the put option. (For more on this, see: Using Options as a Hedging Strategy.)

The other classic hedging example involves a company that depends on a certain commodity. Let's say Cory's Tequila Corporation is worried about the volatility in the price of agave, the plant used to make tequila. The company would be in deep trouble if the price of agave were to skyrocket, which would severely eat into their profits.

To protect (i.e. hedge) against the uncertainty of agave prices, CTC can enter into a futures contract (or its less-regulated cousin, the forward contract), which allows the company to buy the agave at a specific price at a set date in the future. Now, CTC can budget without worrying about the fluctuating commodity.

If the agave skyrockets above the price specified by the futures contract, the hedge will have paid off because CTC will save money by paying the lower price. However, if the price goes down, CTC is still obligated to pay the price in the contract and would have been better off not hedging.

Because there are so many different types of options and futures contracts, an investor can hedge against nearly anything, including a stock, commodity price, interest rate, or currency. Investors can even hedge against the weather.

Hedging is not the same as speculating, which involves assuming more investment risks to earn profits.

Disadvantages of Hedging

Every hedge has a cost, so before you decide to use hedging, you must ask yourself if the benefits received from it justify the expense. Remember, the goal of hedging isn't 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, cannot be avoided. This is the price you pay to avoid uncertainty.

While it's tempting to compare hedging to insurance, insurance is far more precise. With insurance, you are completely compensated for your loss (usually minus a deductible). Hedging a portfolio isn't a perfect science and things can go wrong. Although risk managers are always aiming for the perfect hedge, it is difficult to achieve in practice.

What Hedging Means for You

The majority of investors will never trade a derivative contract. In fact, most buy-and-hold investors ignore short-term fluctuation altogether. For these investors, there is little point in engaging in hedging because they let their investments grow with the overall market. So why learn about hedging?

Even if you never hedge for your own portfolio, you should understand how it works, because many big companies and investment funds will hedge in some form. Oil companies, for example, might hedge against the price of oil, while an international mutual fund might hedge against fluctuations in foreign exchange rates. An understanding of hedging will help you to comprehend and analyze these investments.

Example: The Forward Hedge

Let's take a classic example of hedging using the case of a wheat farmer and the wheat futures market. The farmer plants his seeds in the Spring and sells his harvest in the Fall. In the intervening months, the farmer is subject to to the price risk that wheat will be lower in the Autumn than it is now - and while the farmer wants to make as much as possible from his harvest, he does not want to speculate on the price of wheat. So today, when he plants his wheat he can also sell a 6-month futures contract, say at the current price of $40 a bushel. This is known as a forward hedge.

Six months pass, and the farmer is ready to harvest and sell his wheat at the prevailing market price, which has indeed dropped to just $32 per bushel. He sells his wheat for that price and at the same time buys back his short futures contract also for $32, which generates a net $8 profit. He therefore sells his wheat at $32 + $8 hedging profit = $40. He has essentially locked in the $40 price when he planted his crop.

Assume now that the price of wheat has instead risen to $44 per bushel. The farmer sells his wheat at that market price, and also repurchases his short futures for a $4 loss. His net proceeds are thus $44 - $4 = $40. The farmer has limited his losses, but also his gains.

The Bottom Line

Risk is an essential yet precarious element of investing. Regardless of what kind of investor one aims to be, having a basic knowledge of hedging strategies will lead to better awareness of how investors and companies work to protect themselves.

Whether or not you decide to start practicing the intricate uses of derivatives, learning about how hedging works will help advance your understanding of the market, which will always help you be a better investor.