Beginner’s Guide to Hedging: Definition and Example of Hedges in Finance

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Beginner’s Guide to Hedging: Definition and Example of Hedges in Finance

Although it may seem like the phrase “hedging” refers to something that is done by your gardening-obsessedneighbor, when it comes to investing hedging is a valuable strategy that every investor should be aware of. In the stock market, hedging is a way to get portfolio protection—and protection is often just as important as portfolio appreciation.

Hedging is often discussed more broadly than it is explained. However, it is not an esoteric term. Even if you are a beginning investor, it can be beneficial to learn what hedging is and how it works.

Key Takeaways

  • Hedging is a risk management approach that is used to balance investment losses by acquiring an opposing position in a linked asset.
  • Hedging usually results in a loss in prospective earnings since it reduces risk.
  • The premium for hedging is the money paid for the protection it offers.
  • Derivatives such as options and futures contracts are often used in hedging strategies.

A Beginner’s Guide To Hedging

What Is Hedging?

The best way to understand hedging is to think of it as a form of insurance. When people decide to hedge, they are insuring themselves against a negative event’s impact on their finances. This doesn’t prevent all negative events from happening. However, if a negative event does happen and you’re properly hedged, the impact of the event is reduced.

In practice, hedging occurs almost everywhere. For example, if you buy homeowner’sinsurance, you are hedging yourself against fires, break-ins, or other unforeseen disasters.

Portfolio managers, individual investors, and corporations use hedging techniques to reduce their exposure to various risks. In financial markets, however, hedging is not as simple as paying an insurance company a fee every year for coverage.

Hedging against investment risk is employing financial instruments or market tactics strategically to balance the risk of unfavorable price changes. To put it another way, investors hedge one investment by trading in another.

To hedge, you must execute offsetting transactions in assets with negative correlations. Of course, you must still pay for this sort of insurance in some way.

For example, if you hold shares of XYZ business, you may safeguard your investment by purchasing a put option. However, in order to acquire an option, you must pay a premium.

A decrease in risk always implies a loss in possible returns. So, in general, hedging is a tactic used to mitigate a prospective loss (and not maximize a potential gain).If the investment against which you are hedging produces money, you have generally lowered your prospective reward. However, if the investment loses money and your hedge is effective, your loss will be mitigated.

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Understanding Hedging

In most cases, hedging tactics entail the use of financial products known as derivatives. Options and futures are two of the most used derivatives. You may use derivatives to create trading strategies in which a loss in one investment is compensated by a gain in another.

Assume you hold stock in Cory’s Tequila Corporation (ticker: CTC).Although you are confident in the company’s long-term prospects, you are concerned about possible short-term losses in the tequila business. To hedge against a drop in CTC, you may purchase a put option on the firm, which provides you the right to sell CTC at a certain price (also called the strike price).This is referred to as a married put. If your stock price falls below the strike price, the put option profits will cover the losses.

Another typical hedging scenario includes a business that is dependent on a certain commodity. Assume Cory’s Tequila Corporation is concerned about agave price volatility (the plant used to make tequila).If the price of agave skyrocketed, the firm would be in big difficulty since it would negatively harm their earnings.

CTC may engage into a futures contract to hedge against the volatility of agave prices (or its less-regulated cousin, the forward contract).A futures contract is a sort of hedging mechanism that permits the corporation to acquire agave at a fixed price on a future date. CTC may now budget without being concerned about agave price fluctuations.

If the price of agave rises over the price stated in the futures contract, this hedging approach will pay out since CTC will save money by paying the lower price. However, even if the price falls, CTC is still bound to pay the agreed amount. As a result, they would have been wiser not to hedge against this risk.

Because there are so many different kinds of options and futures contracts available, an investor may hedge against almost anything, including stocks, commodities, interest rates, and currencies.

Disadvantages of Hedging

Every hedging method has an associated cost. So, before you decide to utilize hedging, consider if the possible advantages outweigh the costs. Remember that the aim of hedging is to safeguard against losses, not to earn money. The cost of the hedge cannot be avoided, whether it is the cost of an option or lost earnings from being on the wrong side of a futures contract.

While comparing hedging to insurance is appealing, insurance is significantly more exact. You are fully paid for your loss if you have insurance (usually minus a deductible).Portfolio hedging is not an exact science. Things may go bad quickly. Although risk managers strive for the ideal hedge, it is very difficult to attain in reality.

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What Hedging Means for You

The vast majority of investors will never engage in derivatives trading. In reality, most buy-and-hold investors completely disregard short-term changes. Hedging makes little sense for these investors since they let their assets expand in tandem with the general market. So, why should you learn about hedging?

Even if you never hedge your own portfolio, it is important to understand how it works. Many large corporations and financial firms will hedge in some way. Oil corporations, for example, may hedge against the price of crude oil. Foreign currency rate swings may be hedged by an international mutual fund. Grasp and analyzing these investments might be aided by a rudimentary understanding of hedging.

Example of a Forward Hedge

A wheat farmer and the wheat futures market are two famous examples of hedging. In the spring, the farmer sows his seeds, and in the autumn, he sells his produce. In the meantime, the farmer faces the danger that wheat prices will be lower in the autumn than they are today. While the farmer wants to maximize the value of his produce, he does not wish to speculate on wheat prices. So, in addition to planting wheat, he may sell a six-month futures contract at the present price of $40 per bushel. This is referred to as a forward hedge.

Assume six months have passed and the farmer is ready to harvest and sell his wheat at the market price. The market price has fallen to about $32 per bushel. That is the price at which he sells his wheat. Simultaneously, he buys back his short futures contract for $32, making a net profit of $8. As a result, he sells his wheat for $32 + $8 hedging profit = $40. When he planted his crop, he effectively locked in the $40 price.

Assume the price of wheat has now climbed to $44 per bushel. The farmer sells his wheat at the market price and repurchases his short futures contracts for a $4 loss. Thus, his net earnings are $44 – $4 = $40. The farmer has controlled both his loses and his profits.

How Can a Protective Put Hedge Downside Losses?

Purchasing a downward put option constitutes a protective put (i.e., one with a lower strike price than the current market price of the underlying asset).The put offers you the right (but not the responsibility) to sell the underlying stock before it expires at the strike price. So, if you hold XYZ stock at $100 and want to protect yourself against a 10% loss, you may purchase the 90-strike put. This manner, even if the stock drops all the way to $50, you can still sell your XYZ shares for $90.

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How Is Delta Used in Hedging Options Trades?

Delta is a risk metric used in options trading that shows you how much the option’s price (called its premium) will vary if the underlying securities moves by $1. So, if you purchase a call option with a delta of 30, the price of the option will change by $0.30 if the underlying moves by $1.00. To become delta neutral, you might sell 30 shares (each stock options contract is worth 100 shares) to hedge this directional risk. As a result, delta may also be thought of as an option’s hedging ratio.

What Is a Commercial Hedger?

A commercial hedger is a corporation or product manufacturer that utilizes derivatives markets to hedge their market exposure to the things they produce or the inputs required to generate those items. Kellogg’s, for example, employs maize in the production of their morning cereals. As a result, it may purchase corn futures to protect itself against increasing maize prices. Similarly, a corn farmer may trade corn futures instead to protect against a drop in market price before harvest.

What Is De-Hedging?

To de-hedge is to exit an existing hedge position. This may be done if the hedge is no longer required, if the cost of the hedge is too expensive, or if the greater risk of an unhedged position is desired.

The Bottom Line

Risk is an important, although perilous, component of investment. Whatever kind of investor one aspires to be, having a fundamental understanding of hedging methods will lead to a better understanding of how investors and firms strive to protect themselves.

Whether or whether you opt to begin practicing the complicated applications of derivatives, knowing how hedging works will help you develop your market expertise, which will always help you be a better investor.

Correction – April 6, 2022: A previous version of this item wrongly stated that 300 shares were sold rather than 30.

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