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 is hedging. Hedging is the (partial) limitation of a financial risk. In this article we discuss several methods you can use to hedge as an individual. We also discuss how hedging can help large companies and brokers.
What is hedging?
Hedging refers to limiting your financial risks by taking an opposing position. This is comparable to taking out insurance. Like insurance, a hedge is never free. As an investor, you are paid to take risks. If you reduce the risk, you will have to pay the other party for taking those risks.
There are several techniques you can use to hedge. Hedging is used by large companies, investment funds, but also certainly by private investors. Do you want to know more about hedging? In this article you can find everything you need to know about this topic:
- Advantages: why can hedging be attractive?
- Strategy: how can you apply hedging techniques?
- Cost: how much does it cost to cover your risks?
- Companies: how do large companies apply hedging?
- Hedge funds: what is a hedge fund?
- Brokers: how do brokers hedge?
Hedging is an attractive option when you expect exposure to an above-average risk. Below we will discuss some situations where it may be smart to hedge your financial risk:
Foreign exchange risk hedge
When you purchase shares abroad, you are often exposed to a currency risk. An example can be buying Google shares that are listed in dollars while using euros yourself.
When the euro then drops in value, you get fewer dollars back for your investment. By hedging, you can minimize this risk.
By hedging you can also protect yourself from a strong market decline. When the economic situation is uncertain, this can be an attractive option. For example, if important figures will soon be made public and it is not clear whether the results will be positive or negative, you can use a hedging position to protect your investment.
Hedging stabilizes the results. It costs money but reduces the risk.
There are several ways you can protect an investment position. We will discuss the key strategies you can apply:
Currency risks hedge
When you regularly trade in foreign equities, there is always the risk that your investment will be affected by the foreign exchange rate of the country concerned. You can hedge this risk by also taking a currency position. Let us explain this through an example of an investment in an American stock. In this example you live in a country that uses euros. When your country uses a different currency you can replace the word euro with your own currency.
If you think the value of the euro is going to fall, the best thing you can do is buy dollars and then buy the stock. Afterward, when you sell the share, you will receive more euros back for the same amount of dollars.
Do you expect the value of the euro to increase? Then your investment in U.S. dollars could turn out badly. Even if you make a profit in dollars, your investment in euros can decrease in value. By hedging, you can reduce this risk.
You can hedge this risk by borrowing dollars instead of buying them. When the euro becomes more valuable, you will later have to exchange fewer euros to pay off the debt. This makes it possible to cover the risk of a falling dollar.
Hedging a portfolio
Investors or traders with a long-term vision often own a stock portfolio. When you own several shares, it can be very pricey to sell them all in batches. You would have to pay transaction fees repeatedly. By hedging you can protect your portfolio against large downward price movements.
The best way to hedge your portfolio is to use derivatives. For example, by buying put options or by writing call options on the shares you already own, you can protect your stock portfolio from a decline. You always pay a premium for these options. Therefore, it is important to only hedge your position when there is a good reason for this.
In addition, you can use other tools 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 get a positive result when the price drops. When the entire market collapses, you will be compensated for the loss on your shares (in part). That way, you do not have to sell your stock portfolio.
Hedging a share
It is also possible to hedge a stock. You can do this if you are afraid that the price of the share will drop significantly. You can hedge a share by looking for another share in the same sector.
It is smart to own shares in a sector you have a lot of confidence in. In the oil sector, for example, this could be Shell. Then you start looking 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. When the stock prices of the entire sector falls, your risk is absorbed by this. However, this also ensures that the potential profitability of your position decreases considerably.
Investing in a safe haven
Another way to hedge your investments is to invest in a so-called safe haven. The most famous example of this is gold. During a crisis, you can see that the price of gold often reaches record highs. The profit you earn with gold can be used to (partially) offset the losses on your investments.
Hedging is never free. You should only hedge your positions when you think you are at great risk. It lowers your risk, but also your potential return.
You pay transaction fees over the new position. These costs reduce your return. It is always advisable to choose a low-cost broker, so that you can keep these costs as low as possible.
Hedging also costs money because you miss out on returns. We explain how this works through an example. In this example, you invest in a share of $100. You are afraid the stock is going to fall sharply, which is why you want to protect the position by setting up a hedge. You therefore open a short position besides your stock position.
If the stock does indeed drop to $80, the hedge ensures that you do not lose any money. You lose $20 in value on the stock, but because you have opened a short position you will also receive $20. You can offset the profit and loss. By closing the short position, you even clear the way for a profit when the price recovers.
The share price can also move in the other direction: the price rises by $20 to $120. Your share is worth $20 more, but your short position is worth $20 less. The revenues and costs are again weighed against each other. In this case, you shouldn’t have had a hedge. Without the hedge you would have achieved a return of $20. This reflects another way hedging can cost money; through missed income.
Companies also limit their risk exposure by hedging their positions. For example, an aerospace company is heavily dependent on the price of kerosene. When this fuel suddenly becomes much more expensive, the company’s profitability is compromised.
An airline can cover these risks by concluding a forward contract. With a future, they can buy kerosene for a fixed period at a fixed price. This way, a company can ensure that they can buy certain raw materials at a certain fixed price.
A company can do the same with currencies. Many companies operate internationally on a big scale. A multinational receives income in all kinds of currencies. Here too, a company can stabilize its operating results by buying contracts that offer a certain exchange rate. Without such contracts, companies would be a lot less secure in their international business adventures.
The price of oil fluctuates greatly. Companies can protect themselves from this by hedging.
Investment funds also practice hedging. Hedge funds are the best-known example of this. A hedge fund can take both buy positions and short positions in the market. For example, they buy stocks they consider undervalued and take short positions on stocks they consider overvalued.
Hedge funds can deliver good results in both economic good and bad times. By benefiting from both rising and falling prices, they are more flexible than the more traditional investment funds.
You are probably aware that brokers also hedge. At first glance, this does not seem logical. Hedging is, after all, taking an opposing position and for that reason, your price gain would be a loss for the broker. However, brokers do have a strategy and only hedge the positions that are available as an opposite internally.
Let us say there are 200 purchase orders for Apple shares and 100 sales orders for Apple shares. The broker pays transaction fees when the position actually opens up on the market; therefore it is smarter to cross 100 positions off against each other. The broker will then hedge 100 shares. This makes no difference, as there are 100 customers buying internally at that price and 100 costumers selling at that price. Only 100 shares will have to be sold on the market.
This makes it possible for the broker to pay less transaction costs, and they make a profit on both the short and the long position. After all, the broker earns from the spread and can thus earn money practically risk-free. When the positions are opened simultaneously, the loss of one position can be used to pay for the profit of the other position.
Do brokers hedge honestly?
When brokers hedge in an honest fashion, this strategy does not matter, because, as a client, you do not even notice if the stock was actually bought or sold on the market. It is important to keep an eye on whether the broker is playing fair. If the broker messes with the price, they would earn even more. This is obviously illegal and fortunately most brokers play the game according to the rules. Nevertheless, it is important to be vigilant of this kind of practice!