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.
