Hedge

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Hedge: Definition and How It Works in Investing

A hedge is an investment position taken to reduce the risk of adverse price movements in an asset. It typically involves taking an offsetting or opposite position in a related security so that losses in the primary position are reduced (or gains curtailed).

How hedging works

  • Think of a hedge like insurance: it doesn’t eliminate risk but limits potential losses in exchange for a cost.
  • Hedging usually reduces upside potential as well as downside risk—there is a tradeoff between protection and cost.
  • A “perfect hedge” would be completely inversely correlated with the exposed asset; this is rarely attainable and is costly even when approximated.

Common hedging tools

  • Derivatives (options, futures, forwards): most widely used because their payoff relationships with underlying assets are defined.
  • Diversification: holding assets that tend to perform differently under the same market conditions.
  • Spread strategies: combine derivative positions to limit cost while providing partial protection.

Hedging with derivatives

  • Derivatives derive value from an underlying asset. Options, futures, and forwards are common contracts used to hedge.
  • Hedge effectiveness is often measured by delta (hedge ratio): the change in derivative price per $1 change in the underlying.
  • Cost of hedging depends on downside risk, volatility, time to expiration, and strike selection. More protection (higher strike for a put) generally costs more.

Example: hedging with a put option

Scenario:
– Buy 100 shares at $10 each = $1,000.
– Buy a one-year put with an $8 strike, premium $1 per share = $100.

Outcomes:
– If the stock rises to $12: you do not exercise the put. Holdings worth $1,200 minus $1,100 total cost = $100 net gain.
– If the stock falls to $0: you exercise the put, selling for $8 per share = $800 proceeds; with $1,100 total cost you have a $300 loss. Without the put, the loss would have been $1,000.

This shows the put limits downside but requires an upfront premium.

Diversification as a hedge

  • Buying assets with different economic sensitivities (e.g., cyclical vs. defensive stocks) can reduce portfolio volatility.
  • Diversification may reduce risk without direct derivative costs, but it does not guarantee protection: correlated shocks can cause simultaneous losses.

Spread hedging (example: bear put spread)

  • Buy a put with a higher strike and sell a put with a lower strike (same expiration).
  • This reduces the net premium paid compared with a single long put, providing limited downside protection equal to the strike difference minus cost.
  • Useful for protecting against moderate declines at lower cost than a full hedge.

Hedging for individual investors

  • Long-term buy-and-hold investors often don’t need to hedge daily market moves; fees and complexity can outweigh benefits.
  • Understanding hedging remains useful because large funds and companies use hedges that can affect markets.
  • If you consider hedging, weigh cost, time horizon, and whether the hedge aligns with your goals.

Key takeaways

  • Hedging reduces risk by taking offsetting positions, often using derivatives or diversification.
  • Protection comes at a cost and typically limits upside as well as downside.
  • Choose hedging methods based on the size of the exposure, volatility, time horizon, and acceptable cost.

Frequently asked questions

Bottom line

A hedge is a deliberate trade or allocation designed to limit financial risk. It functions like insurance—effective at reducing losses but not free. Use hedging selectively, after assessing cost, effectiveness, and how it fits your investment objectives.