What is hedging? Here’s what investors need to know

Financial Planners

Svetikd / iStock.com

Svetikd / iStock.com

Hedging is an investment strategy that is simple in concept but difficult to execute. The primary use of hedging strategies is to lock in profits or protect against declines. But how does hedging actually work, and should the average investor know how to do it? What are the potential benefits and risks of hedging? Keep reading to learn the basics.

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hedging basics

If you’ve heard the expression “hedging a bet”, then you at least partly understand what a hedge is. When it comes to investing, “hedging a bet” means taking a position opposite to what you already have. For example, if he had previously bet that Apple stock would go up, his bet that Apple would go down instead would be a hedge against his original position. While it may seem counterintuitive to invest by essentially betting on an existing position, there are at least two common scenarios that investors commonly hedge against.

Why do people hedge? To lock in profits

Imagine the following scenario. You’ve owned Apple stock, one of his favorites, for 10 years. You’ve made a big profit on your stock, but you’re concerned that the share price has risen significantly over the past few months, and you’re wondering if some of your gains will start to pay off. But at the same time, I don’t really want to sell my shares because I still have a positive long-term outlook for the company and I don’t have to pay taxes on the profits. In this case, hedging Apple’s position may make a lot of sense.

In this scenario, hedging against Apple’s position can be achieved in several different ways. One of the most common ways is through options. Here are some examples of this and another method.

Example: Buying a put option

Options can be complex and risky investments, so it’s important to understand how they work. But when used as a hedge, much of the risk goes away.

If you are long, or own the stock, in Apple stock and want to hedge your existing position, you simply buy a “put” option on Apple. A put option gives you a profit when the stock price falls. Therefore, buying a put option on Apple while owning the stock will move your position in the opposite direction.

If you’re right and Apple’s stock price goes down, your stock position will incur a loss, but your put option will give you a profit. Gains and losses may be completely offset depending on how the trade is structured. This completely locks in the profits in your portfolio, even if the value of Apple stock declines.

Of course, the opposite is also true. If you’re wrong and the value of Apple stock actually goes up, the loss on the put option will offset a portion of all your gains.

Another example: shorting a stock

Another way to hedge a long position in stocks is to take an equivalent “short” position in the stock. Shorting a stock is a bit more complicated than simply buying a put option, but the net effect is similar. To short a stock, you need to borrow the stock from your broker and sell it at the current market price. The idea is that if the stock price falls, you can buy it back at a lower price and pocket the profit between the selling price and the buying price.

In the above scenario, if you are long 100 shares of Apple and want to take profit, you can short 100 shares to completely offset your position. For every dollar your long position in Apple loses, your short position will profit by the same amount, completely preventing the loss of your existing profits in Apple.

Why Else Hedging? To Prevent Losses

Just as investors can hedge to protect their profits, they can hedge to prevent losses. The process is the same, but in reverse order. In this scenario, imagine you own a stock, or portfolio, but feel that the macroeconomic environment is deteriorating. Even if you believe in long-term portfolios, a short-term recession can create a bear market and drive down the price of most stocks, even those with long-term promise.

In this scenario, rather than liquidating the entire portfolio (which may incur fees and taxes), you can simply set up a hedge. As the value of the portfolio falls, the value of the hedge rises, protecting against losses without having to adjust the portfolio.

As well as taking profits, you can buy puts or shorts in stocks to protect against market declines. Other option strategies may yield the same results.

Benefits and risks of hedging investments

Done properly, the main risk in hedging an investment is giving up potential upside. For example, if you set up a perfectly balanced hedge against your position in Apple stock, you would not get such a profit even if the stock price doubled. The advantage, of course, is that if Apple’s value were cut in half, it wouldn’t suffer a loss.

Another risk of hedging is that it may incur transaction costs. Many brokers now offer zero commission options trading, but most still charge a commission per contract. Similarly, if you sell a stock short, you may have to pay borrowing fees and margin interest.

Business hedging: to guarantee a known price

Hedging is not just for investors. Businesses generally hedge their costs of doing business to avoid a material adverse effect on their profits. For example, one of the largest operating costs for airlines is fuel costs. Oil prices are notoriously volatile and it is in airlines’ best interest to keep prices stable and as predictable as possible. Therefore, most airlines utilize futures contracts to hedge against oil price fluctuations by guaranteeing the right to purchase oil at a fixed price for a specified period of time.

Other companies may use hedging in slightly different ways, such as farmers hedging against price fluctuations in wheat or corn. Farmers can use futures to guarantee a fixed price at the time of planting their crops, thus avoiding the risk of market failure and unprofitable crops being shipped.

This article originally appeared on GOBankingRates.com: What is a Hedging? Here’s What Investors Need to Know

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