Hedging Your Risk
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.