What
Is Hedging?
The best way to understand hedging is to think of it as insurance.
When people decide to hedge, they are insuring themselves against
a negative event. This doesn't prevent a negative event from happening,
but if it does happen and you're properly hedged, the impact of the
event is reduced. So, hedging occurs almost everywhere, and we see
it everyday. For example, if you buy house insurance, 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 becomes more
complicated than simply paying an insurance company a fee every year.
Hedging against investment risk means strategically using instruments
in the market to offset the risk of any adverse price movements. In
other words, investors hedge one investment by making another.
Technically, to hedge you would invest
in two securities with negative correlations. Of course, nothing in
this world is free, so you still have to pay for this type of insurance
in one form or another.
Although some of us may fantasize about
a world where profit potentials are limitless but also risk free,
hedging can't help us escape the hard reality of the risk-return tradeoff.
A reduction in risk will always mean a reduction in potential profits.
So, hedging, for the most part, is a technique not by which you will
make money but by which you can reduce potential loss. If the investment
you are hedging against makes money, you will have typically reduced
the profit that you could have made, and if the investment loses money,
your hedge, if successful, will reduce that loss.
How Do Investors
Hedge?
Hedging techniques generally involve the use of complicated financial
instruments known as derivatives, the two most common of which are
options and futures. We're not going to get into the nitty-gritty
of describing how these instruments work, but for now just keep in
mind that with these instruments you can develop trading strategies
where a loss in one investment is offset by a gain in a derivative.
Let's see how this works with an example.
Say you own shares of Cory's Tequila Corporation (Ticker: CTC). Although
you believe in this company for the long run, you are a little worried
about some short-term losses in the Tequila industry. To protect yourself
from a fall in CTC you can buy a put option (a derivative) on the
company, which gives you the right to sell CTC at a specific price
(strike price). This strategy is known as a married put. If your stock
price tumbles below the strike price, these losses will be offset
by gains in the put option. (For more information, see this article
on married puts or this options basics tutorial.)
The other classic hedging example involves
a company that depends on a certain commodity. Let's say Cory's Tequila
Corporation is worried about the volatility in the price of agave,
the plant used to make tequila. The company would be in deep trouble
if the price of agave were to skyrocket, which would eat into profit
margins severely. To protect (hedge) against the uncertainty of agave
prices, CTC can enter into a futures contract (or its less regulated
cousin, the foreward contract), which allows the company to buy the
agave at a specific price at a set date in the future. Now CTC can
budget without worrying about the fluctuating commodity.
If the agave skyrockets above that price
specified by the futures contract, the hedge will have paid off because
CTC will save money by paying the lower price. However, if the price
goes down, CTC is still obligated to pay the price in the contract
and actually would have been better off not hedging.
Keep in mind that because
there are so many different types of options and futures contracts
an investor can hedge against nearly anything, whether a stock, commodity
price, interest rate and currency - investors can even hedge against
the weather.
The Downside
Every hedge has a cost, so before you decide to use hedging, you must
ask yourself if the benefits received from it justify the expense.
Remember, the goal of hedging isn't to make money but to protect from
losses. The cost of the hedge - whether it is the cost of an option
or lost profits from being on the wrong side of a futures contract
- cannot be avoided. This is the price you have to pay to avoid uncertainty.
We've been comparing hedging versus insurance,
but we should emphasize that insurance is far more precise than hedging.
With insurance, you are completely compensated for your loss (usually
minus a deductible). Hedging a portfolio isn't a perfect science and
things can go wrong. Although risk managers are always aiming for
the perfect hedge, it is difficult to achieve in practice.
What
Hedging Means to You
The majority of investors will never trade a derivative contract in
their life. In fact most buy-and-hold investors ignore short-term
fluctuation altogether. For these investors there is little point
in engaging in hedging because they let their investments grow with
the overall market.
So why learn about hedging?
Even if you never hedge for your own portfolio
you should understand how it works because many big companies and
investment funds will hedge in some form. Oil companies, for example,
might hedge against the price of oil while an international mutual
fund might hedge against fluctuations in foreign exchange rates. An
understanding of hedging will help you to comprehend and analyze these
investments.
Conclusion
Risk is an essential yet precarious element of investing.
Regardless of what kind of investor one aims to be, having a basic
knowledge of hedging strategies will lead to better awareness of how
investors and companies work to protect themselves. Whether or not
you decide to start practicing the intricate uses of derivatives,
learning about how hedging works will help advance your understanding
the market, which will always help you be a better investor.
