On Wall Street, having an insurance policy if a trade doesn't work out isn't a luxury - it's a necessity.
That's the beauty of hedging, the financial market's way of protecting yourself on a downside fall on a securities trade. Hedging is a time-honored tradition on Wall Street, but it can also be deployed in other financial transaction venues like the real estate market or in the collectibles arena. Companies often use hedging strategies when spending money on assets and buying up other companies.
For the purposes of this article, we'll stick to the financial market - the primary platform for hedging strategies. Let's take a closer look.
What Is Hedging?
Hedging is a financial strategy that aids investors in curbing the downside impact from the potential of other tradable securities, including stocks, bonds, commodities, currencies, options and futures. While hedging does not reduce the risk of losing money on an investment, it does mitigate that risk. That makes hedging a valuable tool for investors looking for some downside protection on a regular basis.
Typically, hedging is considered a risk-management strategy, as its primary goal is to cut or severely reduce the risk of losing money via investments due to market uncertainty. Investment prices ebb and flow, sometimes dramatically so, all the time. Hedging offsets those uncertainty risks by ducking those larger trading losses and (hopefully) locking in a profit on a specific trade. In layman's terms, that means hedging a single asset or investment by investing in another asset or investment, to protect against the loss of money.
Hedging can be used by small or large investors, including individual investors, portfolio managers, brokers, big institutional investors, and of course, hedge fund managers. Each has a vested interest in protecting their investments from downside risks and rely on edge to severely diminish the impact of losing cash on a trade.
It's not just all about Wall Street, either. Whether you realize it or not, hedging is an everyday financial tool used by most Americans.
Take life insurance, likely the purest form of hedging for consumer finances. In exchange for regular payments, a life insurance company will pay out a significant lump sum after you die, thus providing financial stability for your loved ones after you're gone.
The Upsides of Hedging
There are multiple advantages to hedging one investment or asset against another, mostly tied to effective risk management.
Companies can manage debt more efficiently. Via hedging, companies can better manage their debt capacity, by balancing out various investments to reduce the amount of money a company can lose on those investments.
Balancing out investment risk. Investors can protect their investments by hedging one security, fund or even bond against another to curb the risk of losing a significant amount of money on their original investment.
Asset allocation works. Study after study shows that, by and large, proper allocation of assets leads to more robust investment performance with lower risk exposure.
Examples of Hedging
In the real world, hedging usually works in several ways, as follows:
Hedging is often executed using complex investment vehicles called derivatives most notably
For example, if you own stock in ABC Widget Corp., and are reasonably bullish on the company but are bearish on the widget industry, you can protect some down performance in your stock by purchasing a put option on ABC Widget stock, thus providing you with the right to sell ABC Widget at a specific price at a specific time. That way, if ABC Widgets declines below the price you've set with your put option (called the strike price) you'll make some of the money back by the profits you've earned on the put option.
Or, an investor can use futures to hedge against a negative investment or financial outcome.
For instance, in the case of ABC Widgets, senior executives may be concerned about the potential rising cost of the metal that is used to make a widget.
To better insulate their company from the financial loss of skyrocketing metal prices, company financial managers can buy a futures contract to lock in a lower price for metals, thus avoiding any precipitous and profit-threatening upward spike in metal prices down the road.
There is a downside risk that the price of metals will actually decline and that the future "locked in" price will be higher than the actual price of metal when the futures contract is executed. In that event, the company could lose money on the futures contract.
Assuming that ABC Widgets has done its homework and the price of metal rises, the firm should make money on the futures contract execution.
Via Asset Allocation
Portfolio managers routinely hedge their funds by spreading out risk (known as diversification) throughout their portfolio.
For example, the fund manager can diversify his or her portfolio this way:
- 40% U.S. stocks
- 20% International stocks
- 30% bonds
- 10% cash
This hedging strategy, called diversification, works by spreading the risk among several asset classes so losses in one category can offset losses in another category.
Straight-Up Stock Market Investing
An investor may want to invest in ABC Widgets and snap up 500 shares of the firm's stock at $10 per share (or $5,000, plus commission costs.)
If you're not completely sold on the company's long-term performance prospects, you can hedge your investment bet by purchasing an option put contract that enables you to sell ABC Widgets at $8 per share at a specific date in the future.
If the company's stock declines to $6 per share before your option contract execution date, you can insulate yourself from a bigger loss by exercising the contract and sell your shares at the $8 strike price, thus basically cutting your losses approximately in half in the event the company's stock sinks to $6 per share.
Different Forms of Investment Risk
With any investment hedging strategy, the object is to mitigate risk. On Wall Street, there are myriad forms of investment risk and no doubt you'll run into one or more of them when applying hedging strategies.
These are the most common types of investment risk:
This risk category involves shares of common and preferred stocks, stock indexes, stock funds, and stock futures and options. The chief risk is that the securities used to hedge against other securities will swing in the wrong direction you intended, thus losing you money.
Hedge investors often turn to commodities like precious metals, oil and gas, corn, wheat and soy, and other commodities to protect against investment risk.
Investors, especially large companies and big institutional investors, often use global currencies, like the dollar, yen or pound for example, as a hedge on prices paid for goods and services, and as a hedge against a big portfolio position.
Interest Rate Risk
Investors large (usually) and small can also hedge against the movement of interest rates by buying up futures and options with favorable interest rates attached. An example might include a U.S. Treasury Bond future or certificates of deposits (CDs)
Companies hedge against weather conditions all the time. Insurance companies, agricultural firms, concert and event firms, and seafood companies may hedge against adverse weather conditions when large financial assets are on the line.
The Takeaway on Hedging
With all that cash on the line, it's understandable that investors focus on asset appreciation with their investment portfolio - after all, making money is the name of the game on Wall Street.
That said, asset protection is just as important, perhaps even more important, than piling up portfolio assets. With no guard rails installed, it's easy to lose your way and take your portfolio into a ditch if you choose the wrong investments.
That's where hedging can really make a difference. With hedging, investors have an insurance policy against potentially catastrophic investment losses that can put a significant dent in your long-term financial future.
Avoiding those mistakes is the greatest benefit of hedging, which makes it one of the most important tools in your portfolio investment toolbox.
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