Investing 101

Hedging is an investment strategy that aims to offset the potential loss accumulated from another investment. This usually consists of taking an opposite/offsetting position by investing in a different security or the same security in the opposite direction. The aim is to limit your risk in your investments. 

You can think of hedging like purchasing an insurance policy: this mitigates potential future risks by creating a safety net. Similar to purchasing an insurance policy, hedging is not free and the investor must find the right risk-reward tradeoff. The perfect hedge is a strategy which eliminates 100% of the risk in a position or portfolio but this isn’t that easy.

The most common way to hedge a position is through derivatives. If you remember from our previous article, derivatives track the performance of one or more under underlying assets. These include swaps, options, futures, forward contracts and the underlying asset can be almost any instrument (including interest rates). A derivative can be set up that gains a profit when a loss in another investment occurs. 

For example, if you have long shares of AMZN stock, you can buy a put option to mitigate the downside risk. However, by purchasing the put, your potential profit decreases. In the event that the stock goes up, you lose out on profit equal to the premium paid for the put. However, if the stock goes to the ground, the profit you make from the put offsets the losses you make from the long shares, protecting you from losing your entire investment. The greater the downside risk, the greater the cost of the hedge. So, after a point, it becomes inexplicable to purchase additional protection because of the risk-reward tradeoff. 

The effectiveness of a hedge can be measured using the “hedge ratio,” which measures the amount a derivative’s value moves per $1 move in the price of the underlying. 

**Other ways to Hedge**

A more familiar method of hedging investments is through diversification. Since hedging with derivatives can be complicated and requires a decent amount of capital, diversification is simple and provides price protection too. However, there is no guarantee that the diversified assets will move in the opposite direction. For example, during March 2020, diversification in different sectors would not matter since the entire market crashed. 

For retail traders, even though they may not take part in hedging activities, it’s good to understand the topic since large corporations engage in it on a regular basis and if you’re involved with these financial institutions, you most likely will be affected by their actions. Remember, hedging will rarely result in an investor making money. The objective of hedging is only to prevent losses. 

Want to protect yourself from downside in a certain asset/sector? 

Hedging Your Risk

Options

## TL;DR

- Type of contract that gives the holder the right, but not obligation, to transact an asset in the future at a specified price and time. 
- Types of options: calls and puts 

## Calls

If you think the price of an asset is going to rise, you would bet on the price going up and buy a call option. This allows the holder to buy that asset at the stated price by a specific date. For example: Lei is confident that NIO shares will skyrocket as the company increases its global presence. If the stock is currently trading at $38.70, Lei believes that the asset could go higher by the end of the year. He therefore buys 1 $40 call expiring by the end of 2021. With this contract, Lei has bought the right to buy 100 shares of NIO at $40 each before the end of 2021. If the price of NIO skyrockets past $40 before the end of the year, Lei’s option contract will be “in the money:” he can either choose to sell his option and make the difference in the premium amount or he can exercise the option, buy 100 shares of NIO at $40 and make the difference between the trading and strike price. 

## Puts

If you think the price of an asset is going to fall, you would bet on the price going down and buy a put option. Similar to a call option, a put option is bought with a strike price and expiration date in mind. However, unlike a call option, a put option gives the holder the right to sell shares of an asset. Just like Lei chose a strike price higher than the current trading price because he was bullish about the asset, he would do the opposite with a put option. For example: if NIO was currently trading at $38.70 and Lei was bearish about NIO, he would buy a put option for $35 for the end of the year. The only way he makes money is if NIO’s price starts to decrease towards $35 and he either sells the contract to make the difference in the premium or he exercises it and makes the difference between the trading and strike price. Options “in the money” have strike prices lower than the current trading price. 

## Benefits and Drawbacks 

Since options can be thought of as contracts rather than securities, an option holder does not actually own the asset. The advantage of this is that the cost of owning an option contract (100 shares) is much cheaper than actually buying 100 shares. This is because the only cost for buying an option contract is the premium amount. As a result, risk is much lower since you are paying less and therefore your potential losses are also lower. Lastly, combining options can create a strategic position for an investor who is able to hedge their positions. For example, an investor can buy both a call option and put option, to hedge their risk, in case the asset price moves in an unexpected direction. 

Compared to trading common shares, options are traded less frequently and tougher for investors to enter/exit positions quickly. In addition to this, not all stocks listed on public markets have option contracts. Some brokerages also require higher commission fees to trade options. Lastly, due to time decay, the value of your option premium will decrease everyday no matter the movement of the underlying asset. Therefore, trading options can be extremely profitable but requires experience to avoid large losses. 

Calls and Puts

TL;DR

Calls

Puts

Benefits and Drawbacks

Hedging Your Risk