Hedge Definition: What It Is and How It Works in Investing

What Is a Hedge?

To hedge, in finance, is to take an offsetting position in an asset or investment that reduces the price risk of an existing position. A hedge is therefore a trade that is made with the purpose of reducing the risk of adverse price movements in another asset. Normally, a hedge consists of taking the opposite position in a related security or in a derivative security based on the asset to be hedged.

Derivatives can be effective hedges against their underlying assets because the relationship between the two is more or less clearly defined. Derivatives are securities that move in correspondence to one or more underlying assets. They include options, swaps, futures, and forward contracts. The underlying assets can be stocks, bonds, commodities, currencies, indexes, or interest rates. It’s possible to use derivatives to set up a trading strategy in which a loss for one investment is mitigated or offset by a gain in a comparable derivative.

How a Hedge Works

Using a hedge is somewhat analogous to taking out an insurance policy. If you own a home in a flood-prone area, you will want to protect that asset from the risk of flooding—to hedge it, in other words—by taking out flood insurance. In this example, you cannot prevent a flood, but you can plan ahead of time to mitigate the dangers in the event that a flood occurs.

There is a risk-reward tradeoff inherent in hedging; while it reduces potential risk, it also chips away at potential gains. Put simply, 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 receives no payout. Still, most people would choose to take that predictable, circumscribed loss rather than suddenly lose the roof over their heads.

In the investment world, hedging works in the same way. Investors and money managers use hedging practices to reduce and control their exposure to risks. To appropriately hedge in the investment world, one must use various instruments in a strategic fashion to offset the risk of adverse price movements in the market. The best way to do this is to make another investment in a targeted and controlled way. Of course, the parallels with the insurance example above are limited: In the case of flood insurance, the policyholder would be completely compensated for her loss, perhaps less a deductible. In the investment space, hedging is both more complex and an imperfect science.

Hedging With Derivatives

Derivatives 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, is likely to depend upon the downside risk of the underlying security against which the investor would like 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 more volatile security and thus will be more expensive as a means of hedging.

In the STOCK example above, 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. Still, at a certain point, it becomes inadvisable to purchase additional price protection from the perspective of cost-effectiveness.

Example of Hedging With a Put Option

A 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 (STOCK) 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 STOCK for $8 anytime in the next year.

Let’s assume he pays $1 for the option, or $100 in premium. If 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 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 Diversification

Using derivatives to hedge an investment enables precise calculations of risk, but it requires a measure of sophistication and often quite a bit of capital. However, derivatives are not the only way to hedge. Strategically diversifying a portfolio to reduce certain risks can also be considered a hedge, albeit a somewhat crude one. 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, or for two unrelated reasons.

Spread Hedging

In the index space, moderate price declines are quite common and highly unpredictable. Investors focusing on this area may be more concerned with moderate declines than with more 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.

Risks of Hedging

Hedging is a technique used to reduce risk, but it’s important to keep in mind that nearly every hedging practice will have its own downsides. First, as indicated above, hedging is imperfect and is not a guarantee of future success, nor does it ensure that any losses will be mitigated. Rather, investors should think of hedging in terms of pros and cons.

Hedging and the Everyday Investor

For most investors, hedging will never come into play in their financial activities. Many investors are unlikely to trade a derivative contract at any point. Part of the reason for this is that investors with a long-term strategy, such as individuals saving for retirement, tend to ignore the day-to-day fluctuations of a given security. In these cases, short-term fluctuations are not critical because an investment will likely grow with the overall market.

For investors who fall into the buy-and-hold category, there may seem to be little to no reason to learn about hedging at all. Still, because large companies and investment funds tend to engage in hedging practices on a regular basis, and because these investors might follow or even be involved with these larger financial entities, it’s useful to understand what hedging entails to better be able to track and comprehend the actions of these larger players.

The Bottom Line

Hedging is an important financial concept that allows investors and traders to minimize various risk exposures that they face. A hedge is effectively an offsetting or opposite position taken that will gain (lose) in value as the primary position loses (gains) value. A hedge can therefore be thought of as buying a sort of insurance policy on an investment or portfolio. These offsetting positions can be achieved using closely-related assets or through diversification. The most common and effective hedge, however, is often the use of a derivative such as a futures, forward. or options contract.