how a hedge works
using a hedge is a bit like taking out an insurance policy if you own a home in a flood prone area you can protect it from the risk of flooding hedge it in other words by taking out flood insurance you cannot eliminate the risk of a flood but you mitigate the financial losses you could incur similarly if you invest in a hot technology company with the firm belief that its business will thrive over the next quarters you might also invest in a solid consumer staple stock just in case you re mistaken the downside to a hedgethere is a risk reward tradeoff inherent in hedging while it reduces potential risk it also chips away at potential gains hedging isn t free in the case of the flood insurance policy example the monthly payments add up and if the flood never comes the policyholder gets nothing still most people would choose to limit their losses in the world of professional investing hedging works in the same way investors and money managers use hedging practices to reduce and control their exposure to risks they use various tools for the purpose many of them based on derivatives a perfect hedge eliminates all risk in a position or portfolio in other words the hedge is 100 inversely correlated to the vulnerable asset this is more an ideal than a reality and even the hypothetical perfect hedge is not without cost hedging with derivativesderivatives are financial contracts whose price depends on the value of some underlying security futures forwards and options contracts are common types of derivatives contracts the effectiveness of a derivative hedge is expressed in terms of its delta sometimes called the hedge ratio delta is the amount that the price of a derivative moves per 1 movement in the price of the underlying asset the specific hedging strategy as well as the pricing of hedging instruments depends largely upon the downside risk of the underlying security against which the investor wants to hedge generally the greater the downside risk the greater the cost of the hedge downside risk tends to increase with higher levels of volatility and over time an option that expires after a longer period and is linked to a volatile security will be more expensive as a means of hedging in general the higher the strike price the more expensive the put option will be but the more price protection it will offer as well these variables can be adjusted to create a less expensive option that offers less protection or a more expensive one that provides greater protection the hedge fund gets its name from the wide latitude given a hedge fund manager to trade in alternative investments and use risky strategies such as leverage borrowing to invest to achieve results example of hedging with a put optiona common way of hedging in the investment world is through put options puts give the holder the right but not the obligation to sell the underlying security at a pre set price on or before the date it expires for example if morty buys 100 shares of stock plc at 10 per share he might hedge his investment by buying a put option with a strike price of 8 expiring in one year this option gives morty the right to sell 100 shares of that stock for 8 anytime in the next year let s assume he pays 1 for the option or 100 in premium if the stock is trading at 12 one year later morty will not exercise the option and will be out 100 he s unlikely to fret though because his unrealized gain is 100 100 including the price of the put if the stock is trading at 0 on the other hand morty will exercise the option and sell his shares for 8 for a loss of 300 300 including the price of the put without the option he stood to lose his entire investment hedging through diversificationstrategically diversifying a portfolio to reduce certain risks can also be considered a hedge for example rachel might invest in a luxury goods company with rising margins she might worry though that a recession could wipe out the market for conspicuous consumption one way to combat that would be to buy tobacco stocks or utilities which tend to weather recessions well and pay hefty dividends this strategy has its tradeoffs if wages are high and jobs are plentiful the luxury goods maker might thrive but few investors would be attracted to boring countercyclical stocks which might fall as capital flows to more exciting places it also has its risks there is no guarantee that the luxury goods stock and the hedge will move in opposite directions they could both drop due to one catastrophic event as happened during the financial crisis spread hedgingfor investors in index funds moderate price declines are quite common and highly unpredictable investors focusing on this area may be more concerned with moderate declines than severe ones in these cases a bear put spread is a common hedging strategy in this type of spread the index investor buys a put that has a higher strike price next she sells a put with a lower strike price but the same expiration date depending on how the index behaves the investor thus has a degree of price protection equal to the difference between the two strike prices minus the cost while this is likely to be a moderate amount of protection it is often sufficient to cover a brief downturn in the index hedging and the everyday investormost individual investors don t trade derivative contracts investors with a long term strategy such as those saving for retirement can ignore the day to day fluctuations of the markets for investors who fall into the buy and hold category there may seem to be little or no reason to learn about hedging still because large companies and investment funds tend to engage in hedging practices regularly and because these investors might follow or even be involved with these larger financial entities it s useful to understand what hedging entails to comprehend the actions of these larger players 