What is Hedging? How Does It Actually Work?

Hedging. Perhaps one of the most misunderstood concepts in Finance (even though most people engage in some form of it even if they don’t realise it!). But what is hedging exactly? And how does it actually work?

We’ll explain what it is and give you some examples so you have yet another piece of knowledge in your financial toolkit.

What Is Hedging?

So firstly, what is hedging exactly?

Hedging is the practice of protecting one or more positions by opening another position that is contrary to the others.

A “financial hedge” is nothing more than an investment that reduces the risk in another area of your portfolio.

A hedge in the physical sense is a fence that is put up to protect a particular area.

In the same sense, financial “hedging” is the practice of protecting one or more positions by opening another position that is contrary to the others.

How Does Hedging Work?

Hedging might seem like a complicated position to open, especially for retail investors who typically only work with long positions.

But it’s actually a lot more straightforward than it seems.

Ideally, you have a core investment in your portfolio that you wish to hedge.

The core investment could be as broad as a total market fund or as narrow as a specific industry like airlines.

Hedging Strategies

The hedge would be one of these three strategies:

• Reducing the size of your core assets to hold more money in cash
• Adding a position in an asset with an inverse correlation to the core position. This means that the hedged asset has a price that generally moves in the opposite direction of your core assets. We’ll explain this more a bit later.
• Changing the asset allocation (e.g., by adding a position in another market in a similar asset going in the other direction).

When you hedge in the real world, you are more than likely doing so in a derivative market such as options or futures markets.

The reason for doing this is that you can often control a much larger position with considerably less money in derivatives markets.

Derivatives can be extremely dangerous financial securities. You should NOT trade them without a solid understanding of the securities and significant disposable funds (money you can easily afford to lose).

This allows investors to reduce their risk in a core position while also using a minimal amount of money to do so.

As an example, a single S&P 500 index long call option contract for 100 units might cost say, $350.

That position would be worth 100 shares of the S&P500 index (worth say $44,000) if exercised.

Thus, that small $350 position would allow an investor to ‘control’ $44,000 worth of the S&P500 index.

Note, of course, that it is only applicable if the contract is actually ‘exercised’, failing which it’s $350 down the drain.

Now, let’s get into an example of how this information could be used to hedge as a retail investor.

What Is An Example of Hedging?

Let’s look at an example of a hedge that can be done by everyday investors.

Suppose we’re looking at a specific investor, Jo.

First, let’s give Jo a simple position in an airline stock.

Now, airlines are very susceptible to oil prices, right?

If oil prices increase all of a sudden due to an unforeseen shortage, prices of airline stocks may go down.

However, oil stocks would obviously benefit from such a move given their products are now priced higher.

In order to place an effective hedge, Jo the investor opens a position in USO, the United States Oil ETF.

The hedge shouldn’t necessarily be the same size as the core position, however.

It’s constructive to work out an optimal amount by using the formula for Optimal Hedge Ratio for instance.

While it will protect against risk due to sharp oil movements, there are other outside factors that could affect both markets negatively.

Anyone watching the markets in 2020 would know that the vast majority of markets suffered due to the Covid-19 lockdowns.

Using Derivatives for Hedging

Now, let’s consider a slightly more complicated hedge. You can certainly buy stock options as a hedge, but few people understand that you can sell options as well.

A good way to think of selling options is that it’s somewhat similar to selling insurance.

You collect a premium while guaranteeing payment if the position goes against you.

The airline investor Jo can maintain her core airline positions and then, in the options markets, sell one or several put options in USO.

Selling put options (“puts”) means that the investor has the obligation to buy shares of the underlying asset if the buyer of the option decides to exercise that option. This means that losses from selling put options can theoretically be as high as infinity.

If the options expire without being exercised, however, the investor keeps the premiums paid by the buyer.

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What Hedging Strategies Are There?

We gave an overview of the three methods/strategies of hedging earlier, but let’s get more into that.

Increasing Cash, Reducing Position Size

As always, one of the primary methods of hedging is to reduce the size of the position and keep more cash instead.

By doing this, you are taking a cash position and reducing your risk in the core position.

This is a very simple hedge that any investor can use to reduce their risk.

As an example, imagine someone (rather foolishly) invested all their funds in equities. Let’s suppose their total portfolio is worth $100,000.

Now, assume the market decreased by 50%. This would mean their portfolio is now worth $50,000.

Let’s consider an alternate world where this person invested half of their funds in equities and left the other half as cash so that they have:

• $50,000 invested in equities, and
• $50,000 kept idle

The market decreases by 50%. Their equities are now worth $25,000, but the cash remains unchanged at $50,000.

Their portfolio value is now $75,000 meaning their total loss is 25% instead of 50%.

Diversifying the Portfolio

Another method of hedging is also one that retail investors use regularly – diversification.

While we mentioned earlier that a hedge means taking another position with an inverse correlation, simply diversifying your portfolio is a method of reducing risk.

That being said, if you want to diversify with fewer assets, you can look closer at the correlation of your assets.

When two assets are positively correlated, that means that, as the price of one asset rises, the price of the other asset generally tends to rise as well.

Think of the price of gold as a commodity and gold mining companies.

In order to hedge using different assets in the same market, you would consider inversely correlated assets.

That means the opposite as above.

As the price of the core asset goes down, the price of the hedging asset goes up.

The offset between the loss of your core asset and the gain of the other would show the hedge was successful.

Opposing Positions in Derivatives Markets

The third method of hedging is the one from the second example of Jo the investor earlier.

It is also the one most institutional traders take on.

They open opposing positions in derivatives markets that make money when the core assets are losing money.

It should be noted that although any of these strategies can be used by regular investors, you should NOT engage with these lightly.

This is because the risks involved with derivatives can be extreme if not implemented properly.

What Are The Advantages of Hedging?

Hedging has the primary benefit of reducing risk for either a single position or the whole portfolio.

When done effectively (and with some luck), it can also be relatively inexpensive or even make you money.

Hedging strategies that are implemented correctly can also bring about some level of stability and predictability.

For instance, companies might hedge against supply chain shocks by locking in prices for raw materials via futures or forward contracts.

Of course, the downside of this is that they can end up paying significantly greater for the same raw materials.

This holds if, for example, the prevailing market price is lower than the forward price.

What Are The Disadvantages of Hedging?

There is always a cost to hedging, specifically in the form of having to use more capital in order to open the hedging position.

Hedging is not a method to make more money.

Its purpose is to reduce the money you might lose if your investment goes against you.

That being said, investors can see larger risks by using derivative markets to hedge than they would if they had just kept the original position.

As we highlighted earlier on, the losses from derivative positions can end up being as high as infinity.

On a relatively less grim – but still grim nevertheless – note, hedging can end up resulting in the precise event one is trying to avoid.

For instance, companies might choose to hedge their supply chain shocks by locking in prices of raw materials via futures or forward contracts, as stated above.

This is to avoid instances where prices rise.

But if prices fall, then that company would’ve been better off without the hedge vis-a-vis with it!

Wrapping Up: What is Hedging

Regular investors are usually hedging in their retirement accounts without even realizing it.

They have one or several mutual funds that offer a healthy degree of diversification.

And they often have some cash on the side in the unlikely event that the mutual funds go to zero.

While there can be benefits to engaging in more complicated hedges using derivatives markets, investors should be cautious and fully understand those markets before even opening a position.