What is Hedging?
In order to understand what Hedging is, you need to have an idea of why you should want to Hedge in the first place.
If you go to work every day, make money, pay for your house, car, food, family expenses and manage to save up that nest egg you don’t want to lose that hard-earned money, do you?
This is where Hedging is used. Hedging is the practice of using different techniques/positions to lower or balance the risk associated with investing.
Simply put, Hedging is protecting your money as much as possible so you don’t lose any of it.
There are many different ways that people Hedge their investments. Some of the most common hedges investors use:
- Put and Call Options
- Having House Insurance on a Property
- Buying Gold and Silver
- Spread Hedging
Why do investors use Hedging?
It would seem obvious that investors want to protect their investments. Understanding risk is more important than just going out and purchasing a Put Option on Stocks though. Not all Hedging will prevent loss.
The main goal when Hedging is to lower loss and risk or make up for the loss in another area of your Portfolio of Investments. There are real risks associated with investing. For example, while your money is on the Stock Market a real possibility is a Market Crash which is when our economy goes into a Recession and so does the Stock Market. The Stock Market, after all, is made up of many different companies that are all affected by the economy. Whereas we buy Insurance to protect our house from the expense if it ever burnt down. Because houses don’t rebuild themselves it’s a requirement for a Mortgage, not for Stocks.
It’s not just professionals using Hedge techniques. Hedges are all around us throughout our daily lives it may go buy a different name though, insurance. We buy insurance or a Hedge simply to protect against loss or damage to an asset.
Creating a Hedge or insurance is very important for individual investors, portfolio managers as well as corporations. The individual investor, of course, wants to lower risk while trying to maintain maximum returns. The portfolio manager wants to do the same but is now responsible for doing it to other people’s money and the corporation needs a certain amount of return on investment just like the others while protecting assets.
Types of hedges
There are many types of hedges some are easily done such as buying gold coins, while others are more complicated and require substantial knowledge of how investments work.
It may be easier for and individual investor or company to hire a portfolio manager to create hedges for them. The advantage of having a portfolio manager help with your investments is that these professionals have the training, knowledge, and experience to “custom fit” your requirements based on your goals. Also hiring a portfolio manager will, in turn, mean you are not required to know AS much about how your investments get protected.
I still believe you should know exactly where your money is going and what to expect while it’s there. There is no reason for you to ever feel bad about getting explanations about what the investments are, the risks involved or why your money is going into certain areas and not others.
This is why the managers are there, to help you understand. After all, this is your money, not theirs. Now, I say that and lots of people use these professionals so that they don’t have to learn about the stocks bonds or mutual funds they may be purchasing. Being comfortable with your investments is important.
Common types of hedges are:
- Natural hedge
- Options and futures
- Spread hedging
- Buying gold/silver and derivatives of gold/silver
- Insurance of many types
- Stop loss on stocks
- Hedge funds
Remember, a hedge is simply protecting an asset from loss or damage. Here’s how they work and how each one has different qualities. Most people view hedging as only involved in the stock market for portfolio protection. Hedging is better described as asset protection which is done in all asset classes, not just the stock market.
When done properly the use of hedges can significantly reduce or eliminate the possibility of loss or damage to an investment, without significant loss to the return on investment. Just as buying insurance for your house or vehicle it can cost money to hedge investment against loss.
There are investments that in themselves are hedges against the loss in a particular area, called a natural hedge. One of these would be buying an index fund rather than an individual stock that may be in the index fund.
An example would be, if you wanted to make a long term investment into the stock market you can purchase stocks of the s&p500 rather than just purchasing stocks to the company 3M which is in the s&p500 index.
The reason this can help to hedge against loss is that the stock price of 3M may go up or down due to market fluctuations or their own business practices. But, when the market fluctuations of the stock market are spread over the 500 companies a loss in one area can be offset by a gain in another.
In the S&P500 the loss or share price drop of one company can be recouped by another company’s share price in the index going up. This won’t stop a loss on the S&P500 but it can help stabilize some of the market volatility associated with individual stocks.
Another risk for investments is currency risk. That is the exchange rate of different currencies into or from the currency a company may use. A natural hedge for currency risk would be a US company that operates solely in the US. Buying and selling their products in US currency. This will hedge some of the risks if the exchange rates change.
If this same company buys its product from the US and sells in Canada the exchange rate from Canadian dollars to the US dollar can change and affect ROI. (Return on investment)
Options and Futures
An option is a purchased contract that will allow the purchaser the right, not the obligation to purchase or sell a stock at a set price, called a strike price at or before the contract expires.
Options can be very powerful tools when combined with your portfolio. They also offer some protection or a hedge against loss, such as using a put option to limit the potential loss on shorting stocks.
Types of Options commonly Used For Hedging Are:
- Put -the right to sell a stock at a given price
- Call -the right to purchase a stock at a given price
- futures contracts
Put option as a hedge
A put option gives the purchaser the right but not the obligation to sell a stock at a given price, the strike price for a specific period of time.
Using a put option is a type of insurance or hedge against loss. With a put option, you already own the asset, therefore, you want to protect it. Just as you buy insurance for your home to protect it you can use a put option to protect your investment against loss.
If you purchase a stock for $1000 and now you want to protect it because you believe the price is going to drop or may drop over the next month. You can purchase a put option on your stock that will allow you to sell your stock at any point in the next month for $900. This is your insurance to limit a potential loss of investment. So if the stock does drops to $700 during that month you can exercise your put option and sell your stock for the $900 you purchased in the put option.
There would still be some loss in this scenario but it’s a limited loss and it allows you control over how much loss you will have on your investment. Now if after a month your put has expired and the price dropped to $700 you would have to sell at market value because your option is no longer valid.
Call option as a hedge
A call option gives the purchaser the right but not the obligation to purchase a stock at a given price for a specific period of time.
Unlike a put option, you do not own the stock that you are buying an option for. With a call option, you are purchasing a contract that will allow you to purchase the stock at a set price, the strike price for a period of time.
Using a call option as a hedge will allow you to take advantage of if you think that a stock will increase in value at some point within the purchased time for the option. The way this works.
If you purchase a 2-week call option for stock XYZ with a strike price (purchase price) of $23.25 for 100 shares you have the right but not the obligation to purchase the stock XYZ for 23.25 at any point in the next 2 weeks. The total value being $2325.
Therefore, if the stock price of XYZ goes up to $35 within the 2 weeks you can exercise your call option and purchase the stock at the strike price of $23.25. Exercising the call option will cost $2325 but the total value of the stock is now $3500 making you $1175 minus the cost of the call option.
Now let’s say the price of stock XYZ goes down to $20 a share. With a call option, you are not obligated to purchase the stock so you let your call option expire and your only loss is the price of purchasing the option.
A futures contract is a contract that obligates the purchaser and seller to buy/sell an asset for a set price on a specific date. Futures can be used for hedging as well as speculative trading which is trading because you believe the price will rise or fall.
Futures are very similar to put and call option but there are a few big differences. With futures, you still get to trade based on speculation just like a put or call option. That is, you purchase the put/call/future based on your belief that the asset will increase or decrease in value.
Owning a futures contract obligates you to buy or sell the asset at a specific price on a set date.
Being obligated to buy/sell an asset has it’s good and bad. You can make money if the asset price going in the right direction but you can also lose money on the asset if the price goes in the wrong direction. Being that you are obligated to buy or sell the asset locks you into the profit or loss.
Purchasing a futures contract has lower costs in comparison to purchasing a put or call option. But you may miss out on favorable price movements. By locking in a price for the asset you may not be able to take advantage of a favorable price change but you can have a predictable profit.
If a coal mining company buys a futures contract to sell their coal at a specific price they will know exactly what profit they will receive. If the price for coal goes higher than the contract they won’t be able to take advantage of the price but they will still have their set profit. If the price of coal goes down they will make more money by having the futures contract rather than relying on the volatility of the market value.
Spread hedging is purchasing multiple options on a specific asset with the same expiration date. Investors use spread hedging to lower the risk of a downside turn on the stock. The theory behind spread hedging is simple but the execution can be much more complicated.
There are different types of spread hedging, the use of which are based on the speculation of a stock increasing or decreasing in value for a set time. An investor can use a vertical bull spread to take advantage of a rising market. The way the investor would do this is buying one call option on a single stock and selling a call option on the same stock for a higher strike price, both with the same expiration date.
The way it works is, the investor will have the right to buy the stock at a lower strike price if the price of the stock goes up and then, by selling the call option the stock can be sold at the higher strike price. Total profit from the investment will be the difference between the 2 call options minus the cost of the options traded.
Buying gold/silver and shares of gold/silver
Some investors use the purchase of gold/silver or gold/silver shares to hedge against inflation or market volatility.
Investors can purchase gold/silver and use the volatility of the market to stabilize and profit from the investment. If the market is in trouble such as the crisis in 2008 the price of gold increased more the worse the economy got. This gave investors a profit as well as a safe haven in a downturn of the stock market.
Gold also lowers the risks of exchange of inflation. Inflation is the change in the value of a dollar over time. Right now the FED (Federal Reserve) works to have a 2% inflation rate per year. Gold won’t beat the inflation rate but it follows the inflation rate. If you have $100 in the bank based on 2% inflation, a year from now that $100 will be worth $98 in “today’s money”. Gold, however, isn’t affected by inflation like currency is.
Typically investors who are trying to diversify their portfolios are given the advice to hold around 10% of their portfolio in gold/silver.
Insurance of many types
Having insurance on a vehicle is just as important as purchasing a good reliable vehicle. The loss would be if there was a fire or accident causing damage to the asset. A house or boat is in the same area protecting your asset is very important that’s why we purchase insurance on assets.
If you purchased a house and there was a fire causing damage. You would go through your insurance provider to create a claim and the insurance company would rebuild or repair your home. Therefore, having insurance on a property is still a hedge against loss. Without insurance, if the fire happened, you would have to rebuild the house using your own money, not the insurance providers.
Stop loss on stocks
A stop loss is an automatic order to sell for stocks you own.
Being that a hedge is holding a position to limit or lower the risk of investing. A stop-loss lowers the risk but doesn’t create a proportionate recovery of the loss. As in, if the value of the stock goes down a stop loss will just stop the losses already realized.
If john bought 20 stocks for $11.43 each he would spend $228.60 for the stocks. Being that John wants to protect his investment or hedge it, he can put a stop loss on the stocks. If john put a stop loss at a value of $11.10 if the stock value drops down to $11.10 they will automatically sell for him. This will give john a more expectable loss of potential profit.
Now, this isn’t a perfect system one, john still losses money. Two of the markets are only open for a certain period of time. Stock prices still change even when the markets not actively trading. That being said a stop-loss order can only sell your stocks when the markets open. So if John’s stock went lower overnight to $10.12 when the markets open he would be able to sell his stocks incurring a bigger loss.
A hedge fund is an investment strategy that pools investor’s money and invests in a diversified portfolio using complex portfolio construction and hedging techniques to lower risk. For investors, this can be an easy option. You take your money give it to the investment firm managing the hedge fund and they take care of the rest.
A lot of hedge funds are created through businesses such as limited liability, or limited partnership company. This provides a way to separate investors and their money. Not everyone can invest in hedge funds. You need to be an accredited investor or company to be eligible to invest.
A hedge fund is similar to a mutual fund except that, mutual funds have more rules and limitations. One of which is the use of leverage or borrowing money/credit to create bigger returns. Hedge funds are not regulated on how much they can leverage a position for gains. This also leads of course to higher risk investments. Because hedge funds borrow money/debt and use the debt to invest, it can create a higher return but also, bigger losses.
There are many different hedge funds and the structure for the investments ends up being complicated because in order to lower the risk from investing leveraged money all of the positions need to be hedged or protected to try and lower risk.
A dividend is money paid to investors or shareholders of a company from derivatives of operations such as profits or reserves.
When you purchase stocks you are purchasing a small fraction of the given company. A profitable company generates a positive income and some of these companies pay dividends to their shareholders. Usually, this will happen on a quarterly or yearly basis and the amount paid out to investors can vary company to company.
So how is using dividends a hedge? Some people use dividends as a hedge because they produce more than just capital gains. If you purchase stocks that pay dividends the company takes a percentage of the profits or reserves and pays this out to the investors. The idea is that the investment will pay for itself over time. So if you have $10,000 in dividend-paying stocks eventually these stocks will have paid out $10,000 covering your position while still controlling the primary asset.
A lot of investors reinvest the dividends back into the market. Now your money is doing double the work because the dividends being paid are reinvested. This compound effect can have huge results but, there is always a risk. Companies can choose to lower the number of dividends paid to investors. Some companies stop paying dividends entirely. Also, having a dividend-paying stock won’t stop a loss on the value of the stock.
What to take away.
Risk management is what hedging is all about. Investors who properly use hedging techniques are protecting their investment from loss or damage. No one wants to lose their money, we want to see our money grow and provide more value today than yesterday.
There are lots of different hedging techniques. Getting the proper information and learning how and when to use the techniques is the most important part of investing.
Understand risk and risk management to limit or eliminate loss should be a priority for every investor and it starts with paying yourself first.