What if you could get an insurance policy for your portfolio? Well, you can -- smart investors have been doing it for years. It's called hedging, and believe it or not, it's not too expensive or too complicated for you to put to work for your investments. Here's the rundown.A Brief History of Hedging Believe it or not, hedging has nothing to do with foliage. It actually gets it name from the Roulette table. In Roulette, players can place a bet on multiple numbers by putting their chips on a border-line called a hedge. When you play a hedge-line in Roulette, your chances of seeing a payout are increased (albeit at a lower rate) because you're betting on more numbers. Just like in the casino, investment hedging is a way to increase your portfolio's upside and reduce overall risk. A hedge is an investment you make to protect another investment. It's a lot like insurance. One of the most common ways to hedge an investment is by pairing a stock with the opposite position in a related stock. In other words, if you think Company A is going to increase in value, but you want to limit your downside, you could short an index fund that tracks Company A's industry. That way, if the industry takes a hit, your short gains will make up for any losses you take on Company A's stock. Even if you weren't familiar with hedging before, chances are your portfolio is somewhat hedged right now.
In a broad sense, diversification is a sort of natural hedge. Think about it - by investing in a diverse range of stocks, you're limiting the risk that any one position will hurt your overall portfolio. But that's just the tip of the iceberg; there are many more ways to hedge that are more effective. Learning to Hedge With Indevus Pharmaceuticals Let's take a look at a real hedging scenario. Indevus Pharmaceuticals ( IDEV) took a big hit on Wednesday -- a 65% tumble. That makes this stock a great example of how to hedge. For starters, let's say that you're worried that the biotech industry is a little too volatile right now. If you want to protect an investment against turbulence in an industry, one of the simplest ways is by shorting an index fund or industry exchange-traded fund (ETF) or if you want to avoid margin, just buying a short ETF (see " How Short ETFs Make Money"). For example, you could just take a short position in the iShares NASDAQ Biotechnology Index ( IBB), and be shielded from an industry-wide loss. That's the kind of hedge that would have saved your shirt if you were a Yahoo! ( YHOO) shareholder when the technology bubble burst in 2000. But that would not have been a good hedge for Indevus. Assuming you have done your homework, you would know that Indevus is a small-cap drug company that's working on developing a couple of new drugs. Sound like risky territory? It turned that it was. News about Federal Drug Administration (FDA) approval for one of the company's drugs caused this week's sharp drop in stock price, but the rest of the industry didn't budge.
How could you have hedged here? Well, options are certainly a good option. Buying put options on Indevus would be a way to lock a "floor" in for the stock. Those put options give you the right to sell shares of Indevus for a pre-set strike price, so if you bought $5 puts, you would be able to sell your shares for a lot more than the $1.38 they're currently trading at. Let's say that you bought puts, but the stock did fine after all. That's the beauty of options -- you can just let them expire and take the gains from your long position. Beyond Stocks Hedging isn't just for stocks. It's a method that's also used heavily by people who trade commodities and foreign exchange. Since options are just for stocks, there are other derivatives (like futures) that come into play for hedging commodities and the like (for more on derivatives, check out " A Look at Derivatives and Precious Metals"). Hedging is often used as a business strategy as much as an investment strategy. Businesses that spend lots of money on commodities (or commodity-based goods) can increase their profitability by using hedges. A lot of hedging goes on in the energy world. For example, airlines often have in-house trading desks that hedge against the rising cost of jet fuel, and Enron's infamous rise to prominence came about largely because of the gas hedging that they helped make common practice. But despite the awesome benefits hedging can provide, like anything else, it does have its detractors.
Insurance Isn't Free If hedging is an insurance policy for your portfolio, it should come as no surprise that taking advantage of this tactic isn't free. It does cost money to place shorts and buy those put options. Another cost is performance. When you reduce an investment's risk, you're also reducing the potential payoff that it can provide. When you hedge a stellar investment you might just be cutting yourself out of some serious profit potential. For both of these costs, the trick is to sacrifice less than you're benefiting. And while that might sound like a tall order for a new investor, as you gain experience with hedging, things become much more intuitive. To delve deeper into the world of hedging, don't miss these lessons on TheStreet.com:
"Finance Professor: Five Hedging Techniques You Must Know" "Getting Started With Options" "Using Leverage to Reduce Risk" "Risk Management: Learning to Fly"