The concept of hedging can be defined as mitigating some of the risks you are willing to assume at any point in time. For example, when a trader or corporate treasurer decides they want to hedge, they have determined that it’s in their best interest to reduce their risk to remove some of the volatility they could experience. There are dozens of ways to hedge your exposure. This activity could include exiting some of your positions. It could also include entering a new position in a correlated asset or purchasing options to protect you against an adverse move in your trade.
What is Hedging?
A hedge is a trade that you can make where the goal is to reduce the risk of the volatility of your returns. Most of the time, you might be considering mitigating adverse price movements in an asset you currently own. Typically, a hedge consists of taking an offsetting or opposite position in a related security.
How Does a Hedge Work?
A Hedge is an insurance policy. Usually, when people purchase a car, they buy insurance to protect them if they get into an accident. Most people, when they buy insurance, are concerned with a catastrophic event. If you have a fender bender with your car that costs $100 to fix, you probably will not use your insurance. If you total your car and are on the hook for $40,000, your insurance will come in handy.
Hedging works the same way in a trading environment. Traders use hedging practices to reduce their exposure to risks. The best way to do this is to make another investment. Of course, the parallels with the insurance example above are limited. In the example where you would purchase car insurance, you would be completely protected if you total your car. In the investment space, hedging is more of an imperfect science.
Most of the hedging takes place in the trading world through derivatives contracts. Derivatives are securities that can move in tandem with the underlying asset. Derivatives include options, futures, and forward contracts. The underlying assets can be stocks, bonds, commodities, currencies, indices, or cryptocurrencies. The use of derivatives can be effective hedges against an adverse movement in underlying assets since the relationship between the two is usually consistent. For example, the S&P 500 futures contracts generally move in tandem with the S&P 500 index. When you hedge, you can use derivatives to set up a trading strategy where the loss for one investment offsets the gain in another.
For example, you might have a trade where you purchase $1,000 of the Nasdaq 100 ETF. Before a significant economic event, you decide to reduce your exposure to the Nasdaq 100 but don’t want to sell your position. To mitigate your risk with a hedge, you could sell $500 worth of Nasdaq 100 futures cutting your exposure in half. This type of strategy will also work if you have a short position in an underlying asset. For example, you might be short $1,000
What Kind of Hedging Strategy Should You Choose?
Your hedging strategy is predicated on the downside (or upside) you are trying to protect. Typically, the cost of the hedge rises with the size of the position. Downside risk often rises when volatility starts to rise. One way to hedge volatility and downside risk is to use an option to hedge your position. An option is a right but not the obligation to purchase or sell an asset. Options have expiration dates and different prices, call strike prices, where you agree to buy or sell an asset.
For example, if you own $1,000 of the Dow Industrial Average, you can consider purchasing a put option that will pay off if the Dow crosses below a specific level. To buy a put option, you need to pay the option seller a premium. The premium is based on the time to maturity, the strike price, and the volatility priced into the market by options traders. This type of option volatility is called implied volatility.
Futures, forwards, and options help you eliminate risk, but they are often not a perfect hedge. Unless you are willing to eliminate your risk, you will experience a partial offset to your position.
The Bottom Line
Hedging is an activity where you can eliminate part of your risk exposure. You can hedge using products called derivatives that will mimic the movements of the assets that you own. You can hedge both short and long positions. You can think of hedging as purchasing insurance. You are trying at certain times to reduce the amount you lose and give up on the size of your gains. Hedging instruments can mitigate most of your risk.