What is hedging?

Definition:

Hedging is a means of protecting profits or reducing losses in certain assets by buying or selling another asset.

How does hedging work?

Hedging is an advanced risk management strategy. Hedging is akin to insurance. Theoretically, hedging can limit the potential losses of an asset you own or constrain the price of the asset you want to buy. Generally, if the value of your investment decreases, the value of your hedge increases. If the value of your investment increases, the value of the hedge typically declines. Often, options are used to buy or sell a stock or other assets at a specified price and time in hedging strategies.

Types of Hedging Strategies

Typically, investors create hedges using various types of derivatives such as options, futures contracts, and forwards. Exchange-traded funds that include inverse options can also serve as hedges in certain situations, but they are investments fraught with risks.

Protective Options

Options give you the right to sell your stock at a specified price for a specific period. You can choose the price at which the options are sold (strike price), providing you a security base for your stock’s price. They can limit or eliminate losses. However, they are not free. You have to pay for them, so you could lose money if your stock doesn’t drop enough to reach the strike price.

Written Calls

Written calls give you the right to buy a stock at a specified price for a specific period. If you want to hedge your shares in Apple, you can sell written calls. These calls will generate income in the form of premiums that the buyer pays you unless the stock price reaches the strike price. So, if the stock price declines as expected, you will profit from the written call. However, if the stock price reaches the strike price, the profits are capped at the strike price.

Collars

Collars are a combination of protective options and written calls. You buy protective options to guard against a stock’s price decline, and in theory, the written calls you issue generate premiums that you can use to pay for the protective options.

What does this mean for individual investors?

Hedges can be costly in some cases, and price fluctuations are expected over time. Because of this, hedging is not recommended for investors who simply want to buy and hold stocks. If you choose to create a hedge, ensure you understand the mechanics of the hedge, including (when applicable) the strike price and how much you will pay or receive as premiums.

Frequently Asked Questions (FAQs)

What is hedging in stocks?

Hedging in stocks means purchasing an asset that moves in the opposite direction of the stocks. It can be an option, a futures contract, or a short sale.

How much does hedging cost?

Hedging strategies often use options and futures to hedge losses. Options and futures have limited timeframes and can be sold for a premium. The premium is affected by the expiration date, the stock or other asset price, and volatility.

What does it mean to hedge a portfolio?

Investment portfolios usually contain a mix of different asset classes, such as stocks, bonds, real estate, and cash, along with many individual holdings. Hedging a portfolio entails partial or total protection of the portfolio against losses. Hedging is typically a short-term strategy. For example, an investor who believes stock prices are on the decline can hedge part of the equity in their portfolio using an inverse exchange-traded fund.

Source: https://www.thebalancemoney.com/hedge-what-it-is-how-it-works-with-examples-3305933