Hedging: What is hedging and how can you do it yourself?
As an investor, you want to achieve the highest possible return with minimal risk. One technique that can help with this is hedging. Hedging is (partially) covering a financial risk. In this article, we discuss various hedging strategies that you can use.
What is hedging?
Hedging is the practice of covering your financial risks. You can compare hedging to taking out insurance. Just like insurance, a hedge is never free. As an investor, you are paid to take risks. When you reduce the risk, you will have to pay the other party for this.
There are different techniques that you can use to hedge. Hedging is used by large companies, investment funds, but also by private investors.
What are the best hedging strategies?
Do you want to hedge yourself? Below are various hedging strategies that you can apply.
Protecting a stock or fund against a falling price
Are you afraid that a specific stock or fund may decline in the future? You can hedge this risk.
For example, when a stock is trading at $10, you can buy a put option on the price of $8. If this option costs $1 per share, it provides the following protection:
- Price rises to $12: you still have a profit of $1 per share.
- Price drops to $0: your loss is $2 per share instead of $10 per share.
- Price does not move: you lose the $1 you paid for the hedge.
Do you want to learn more about using put options to protect your investments? Then read this article.
Hedging currency risk
When you buy stocks abroad, you often run a currency risk. For example, you buy shares in Google that are listed in dollars while you use euros yourself.
When the euro subsequently decreases in value, you get fewer dollars back for your investment. You can hedge this currency risk by entering into a forward contract on currency. You can exchange a certain amount of dollars for a certain amount of euros against a set exchange rate.
It is also possible to hedge this risk by borrowing dollars instead of buying them. When the euro becomes more valuable, you will need to exchange fewer euros later to repay the debt. This way, you hedge against the risk of a falling dollar.
Hedging a portfolio
Investors or long-term visioned investors often own a stock portfolio. When you own different stocks, it can be expensive to sell them in case of a crisis since you have to pay transaction fees. By hedging, you can still hedge the portfolio against a major hit.
The best strategy to hedge your portfolio is to use derivatives. For example, by buying put options or writing call options on the stocks you already own, you can protect the portfolio against a decline. However, you do pay a premium for these options. Therefore, it is important to only hedge your position when there is a good reason to do so.
You can also use other instruments to hedge your portfolio. For example, you can take a short position on an index by using a CFD or future. With a short position, you achieve a positive result when the price falls. When the entire market collapses, you can compensate for the loss on your stock portfolio with the short position.
Pairs trading hedging strategy
With the pairs trading hedging strategy, you buy a stock in a sector that is undervalued and open a short position on a stock that is overvalued.
For example, in the oil sector, Shell may be undervalued. Then you look for a stock that you think is slightly overvalued. This could be a related company like Total. You then take a short position on this stock. This way, you hedge against the risk of a sextor wide decline.
Investing in a safe haven
Another method to hedge your investments is to invest in a safe haven. The most well-known example of this is, of course, gold. During a crisis, you often see the price of gold reaching record highs. You can use the profit you make from gold to compensate for the losses on your investments.
Diversification as a hedge
Diversification within a portfolio can also be seen as a hedge. During good economic times, you often see that growth stocks perform well. When you expect the stock market climate to deteriorate, you can apply more diversification to your portfolio and thereby lower the risks.
You can sell a portion of your risky stocks and buy more defensive and cyclical stocks, such as tobacco producers or utility companies. If your prediction is correct, the loss will be offset by these more stable stocks. However, if the economy performs well, you will miss out on potential returns. Hedging is never free!
How much does hedging cost?
Hedging is never free. You should only hedge your positions when you think you are taking a big risk. It lowers your risk but also your potential returns.
Transaction Costs
You pay transaction fees on the new position. These costs reduce your return. It is always advisable to choose a cost-effective broker to keep these costs as low as possible.
You potentially miss out on returns
Hedging also costs money because you miss out on returns. We will explain this with an example. In this example, you invest in a stock for $100. You are afraid that the stock will significantly drop in value, so you protect your position by setting up a hedge. You therefore open a short position next to your stock position.
When the stock does indeed drop to $80, the hedge ensures that you do not lose money. You lose $20 in value on the stock, but because you opened a short position, you also receive $20. The loss and profit can offset each other. By closing the short position, you even clear the way to achieve price gains when the stock recovers.
It can also go the other way: the price rises by $20 to $120. Your stock is worth $20 more, but your short position is worth $20 less. The revenues and costs are once again weighed against each other. In this case, you should not have had a hedge, since you would have achieved a return of $20 without hte hedge. Another cost for hedging is lost income.
How do companies hedge their risks?
Companies also hedge their risks by hedging their positions. An airline, for example, is highly dependent on the price of kerosene. If this fuel suddenly becomes much more expensive, the profitability of the company is at risk.
An airline can hedge these risks by entering into a forward contract, such as a future. With a future, they can buy kerosene for a fixed period at a fixed price. In this way, a company can ensure that it can buy certain raw materials at a certain fixed price. This is also called a forward hedge.
A company can do the same with currencies. Companies increasingly operate internationally. A multinational receives income in different currencies. Here too, a company can stabilize its business results by entering into contracts at a certain exchange rate. Without these types of contracts, the business world would be facing more uncertainty.
What are the disadvantages of hedging?
Hedging always costs money: you pay transaction costs, and in the long run, you also miss out on returns. Hedging is therefore very strategic and only suitable for investors with sufficient experience.
Conclusion: How can you hedge?
Anyone can hedge with a broker account. Hedging involves taking out an imperfect insurance policy on your investments. Because hedging often involves complex derivatives, this strategy is not suitable for everyone. However, by applying hedging intelligently during uncertain times, you can increase the returns on your investments.
Frequently Asked Questions About Hedging
A hedge fund can take both long and short positions in the market. For example, they may buy stocks that they consider undervalued and take short positions on stocks that they consider overvalued.
Hedge funds can achieve positive results in both good and bad economic times. Because they can profit from both rising and falling prices, they are more flexible than more traditional investment funds.
A perfect hedge eliminates the entire risk of the portfolio. This means that a perfect hedge moves exactly in line with the securities within a portfolio. A perfect hedge does not exist because heding is not an exact science. Even with a hedge, you still face investment risk.
The effectiveness of a hedge is expressed in delta. Delta indicates how much the price of a derivative moves when the underlying asset increases or decreases by $1. With a delta of 0.5, the derivative increases or decreases by $0.50 when the underlying asset moves by $0.5. Delta is also seen as the hedge ratio of a derivative.
De-hedging is closing an existing hedging position. This is useful when the hedge is no longer necessary. You close a hedging position simply by selling the financial instrument used.
You may have read that brokers also hedge. At first glance, this may not seem logical. After all, hedging involves taking an opposing position, and in this way, a broker’s profit on a price increase would be a loss. However, brokers are not foolish and only hedge the positions that are internally available in the opposite direction.
For example, at Broker X, there may be 200 buy orders for Apple stock and 100 sell orders for Apple stock. The broker pays transaction costs when the position actually opens on the market; it is much smarter to offset 100 positions against each other. The broker will then hedge 100 shares. This makes no difference because there are already 100 customers buying at that price and 100 customers selling at that price. Only 100 shares need to be actually sold on the market.
In this way, the broker does not pay transaction fees and makes a profit on both the short and long positions. The broker earns from the spread and can thus make money virtually risk-free. The positions are equal, as the long position is exactly the opposite of the short position. When the positions are opened at the same time, the loss from one position can be used to pay the profit from the other position.
Do brokers play fair?
When brokers hedge fairly, it makes no difference because as a customer, you don’t even notice whether the stock has actually been bought or sold on the market. However, it is important to keep an eye on whether the broker follows the rules. If the broker were to manipulate the price, they would earn even more. This is obviously illegal, and fortunately, most brokers play by the rules. Be vigilant for such practices!
Auteur
Over Alex Mostert
When I was 16, I secretly bought my first stock. Since that ‘proud moment’ I have been managing trading.info for over 10 years. It is my goal to educate people about financial freedom. After my studies business administration and psychology, I decided to put all my time in developing this website. Since I love to travel, I work from all over the world. Click here to read more about trading.info! Don’t hesitate to leave a comment under this article.
