Hedging is an important aspect to understand when getting into the stock market. It can be a life saver when markets are selling off and you need to protect your positions.
Read on to learn more!
Intro to Hedging
If you’ve ever sat at a blackjack table, you know that gut punch feeling of seeing the dealer flip their first card to reveal an ace. ‘Oh no, she’s got 21 for sure,’ you think as you stir your watery gin tonic.
The casino knows you’re thinking this way too – that’s why there’s a little imprint on the table reading ‘Insurance Pays 2-to-1’.
When the dealer’s first card is an ace, many casinos allow bettors to place an insurance bet on the side. The insurance bet pays out 2 to 1 if the dealer does wind up with blackjack, which happens about 33% of the time when the first card is an ace.
If the dealer flips blackjack, a player with an insurance bet will lose the hand, but win the side bet and break even. Of course, if the dealer turns over a 9, the player now runs the risk of losing both bets.
When an investor talks about hedging, they’re talking about something similar to the insurance bet offered to the blackjack player. A hedge is insurance against an adverse event, whether it’s a dealer getting 21 or a stock crashing 25%.
Investors can hedge their bets in a couple different ways, many of them involving derivatives like options and futures.
Hedging can help protect your assets during market downturns, but just like at the blackjack table, there are drawbacks. After all, a hedge is inherently a bet against your own interests.
What is Hedging?
Hedging has been a strategy in business and investing for thousands of years, but sociologist Alfred Winslow Jones is credited with modernizing the concept. In 1949, Jones created a “hedged” fund in order to protect his clients from losses in the market.
Jones implemented his strategy by short-selling stocks and ramping up the leverage, thus giving birth to the first hedge fund. Hedge funds today use a variety of different strategies to make money in all kinds of markets, but Jones’s original hedge fund simply wanted insurance against risk.
Hedging is still used by investors to protect themselves from downside risk, although with a variety of different methods. One of the simplest forms of hedging is the typical 60/40 stock and bond portfolio carried in the retirement accounts of millions of Americans.
Middle-aged retirement savers commonly hold 60% stocks and 40% bonds, which produces inferior long-term gains to a 90% stock portfolio but also loses less money in a market drawdown (at least in theory).
As retirement age approaches, these investors increase their exposure to bonds while decreasing exposure to stocks.
If a crash occurs close to a person’s retirement age, a hedged portfolio of stocks and bonds will preserve the capital they’ve spent decades accumulating.
Day traders use much more complex strategies when hedging, but the thought process is the same. If a trader holding airline stocks is worried about oil prices or economic uncertainty, they may want to mitigate short-term risk without selling their stocks.
To hedge the airline company investment, the trader may place a separate order for a security that would appreciate when the airline stocks decline.
By hedging, the trader decreases the maximum profit possible from their original investment, but also preserves some capital if the stocks crash.
How it Works
Hedging is an effective strategy in times of uncertainty because it removes a significant portion of the risk involved with an investment.
Hedges are everywhere – we’ve already pointed out the familiar 60/40 stock and bond portfolio held by retirement savers. In a way, all types of diversification are hedges.
That’s why a portfolio of 20 stocks is considered a safer investment than a portfolio of just Amazon and Google shares.
Should you hedge your investments if you’re a day trader? It depends on your risk tolerance and your comfort using derivatives.
It’s easy for a buy-and-hold investor to hedge: ETFs, Target-Date funds, and portfolio rebalancing are all simple methods of mitigating market risk.
But if you want to hedge as a day trader, you’ll need to learn to use some more complex derivatives like options and futures.
Pros and Cons of Hedging
Pro: Hedging can protect your capital in the case of a Black Swan event. When Lehman Brothers collapsed in 2008, stockholders were left with useless holdings that had cratered to a fraction of their original price. A hedge can keep you in business when things go from bad to catastrophic.
Con: Hedging takes away some upside from your trading. Minimizing risk doesn’t correlate with maximizing profit, so a hedge is only worth it if you expect a sudden spike in volatility. If your investments are slowly chugging higher, a hedge will be more of a burden than an effective protection plan.
Pro: Investors with low tolerance for risk can use a hedge to preserve not only capital, but peace of mind. It’s said that investors often choose between two extremes – eating well or sleeping well. A risky investment portfolio might produce gains that allow the investor to buy expensive steak every night, but they might toss and turn at night thinking about uncertainty. By hedging, investors can eat well from consistent gains AND sleep well at night knowing they aren’t taking too much risk.
Con: Hedging usually involves purchasing a financial asset to offset the risk of another separate financial asset. As any trader knows, purchasing financial assets always comes with transaction costs, even if commission-free trading is now the norm. If your hedging strategies aren’t well-planned and executed, the capital you seek to preserve could be eaten up by fees and trading costs. Always consider the trading costs as well as the profit/loss estimates when hedging.
Examples of Hedging
- Diversification – The oldest and most prominent form of hedging around is simple diversification. By buying a variety of different financial assets, your portfolio isn’t beholden to a single security or industry. If tough times hit the auto manufacturers and you hold GM and Ford, a portfolio balanced with tech and banking stocks could offset the losses from the auto stocks. Target-Date funds are great examples of reducing risk through diversification.
- Covered Call Options – A covered call is when you buy a stock while writing (ie. selling) call options for that same stock. If you purchase ABC stock with a goal of long-term price appreciation, there may be flat trading periods where the stock bounces around in a defined range. If you expect this range-bound trading to continue, you can sell a call option on the stock that will deliver income while your stock is trading flat. Note that this strategy can backfire during periods of heavy volatility, but using covered calls is one of the most common forms of hedging with options.
- Out-of-the-Money Put Options – To protect stock holdings against an unknown negative event (or black swan), some traders choose to buy long-dated put options with a strike price far below the current stock price. These put options are attractive because they’re inexpensive, but will almost always expire worthless. Unlike covered calls, out-of-the-money put options only save money if a serious market correction occurs. Much like buying a “catastrophic” healthcare plan, this strategy is cheap insurance against worst-case scenarios. Just understand you’ll spend 99% of your trading time bleeding gains using out-of-the-money puts
- Hedging with Commodity Futures – Many industries depend on cheap commodities to keep prices low or profits high. When oil prices are low, airlines can fuel their jets inexpensively. If the price of coffee skyrockets, Starbucks and Dunkin Donuts will need to raise prices on their drinks in tandem. When companies have this type of relationship with a tradable commodity, investors can use that to their advantage. If a trader is holding Southwest and Delta Airlines shares, they can hedge those holdings by purchasing oil futures contracts. If oil prices rise rapidly, the airline stocks will take a hit due to the increased fuel costs, but the trader will make money off the futures contracts
Hedging your trades can prevent a blowup and keep your positions manageable during periods of uncertainty.
If a trade turns against you, a properly-placed hedge can keep you from losing the bulk of your investment. But remember that hedging also comes with drawbacks and inconveniences.
When you hedge a trade, you’ll need to purchase a security that moves in the opposite direction of your initial investment. Not only does decrease your maximum profit level, but you’ll be paying transactions costs on two trades instead of one.
Hedging a trade is buying insurance.
And like auto and health insurance, you need to decide what level of protection is right for you. Do you want to protect your assets with a full coverage car insurance plan or take the risk of only buying state minimum coverage?
And likewise, would you prefer to just let your trades ride or do you want to take a little off the top to preserve your capital? It’s a personal decision – there’s no right or wrong answer.
Just be sure to understand the pros and cons of hedging before adding it to your trading toolbox.