What is a hedge?
A hedge is a strategy that’s designed to protect an investment against losses. It’s like an insurance policy, as they both provide financial relief when things go wrong.
How hedging is done
The idea behind hedging is to balance out risks in an investment portfolio. This could involve owning shares that move in opposite directions. For example, when shares in an oil company rise – indicating financial strength – shares in an airline might tumble.
Another popular hedging technique involves derivatives – special types of contracts which derive their value from underlying assets such as stocks, bonds and commodities.
Let’s imagine that Philippa owns 100 shares in a housebuilding company, and each share is currently worth $10. She wants to protect herself in case the share price falls dramatically.
By using options – a type of derivative – Philippa can enter into a contract where she has the choice, but not the obligation, of selling her shares at $8.50 each at any point in the coming 12 months. If the share’s price subsequently dipped to $2, her options contract would mean she could still get $8.50 a share – saving her from a loss of $6.50. If the share’s price continued to rise, she can allow the contract to expire without taking any further action.
Hedging is typically a strategy that’s deployed by advanced investors who are pursuing short-term gains yet want to inoculate themselves against the risks of a volatile market. Generally speaking, hedging is not an approach relied upon by investors thinking long term. Hedging is often used in combination with leverage to maximize returns from small market inefficiencies.
These strategies can be difficult to perfect, and there’s no guarantee of removing risk entirely. A combination of shares that usually move in opposite directions could both head downwards due to an unforeseen event – exacerbating losses that an investor was trying to prevent. And for investors who want to maximize their profits, the costs associated with hedging can be a downside – especially considering they might end up spending money on derivatives they’ll never use.