What is a hedge
A hedge is an investment intended to reduce the risk of unfavorable fluctuations in the prices of an asset. Normally, hedging involves taking a clearing position in a related security.
Coverage is analogous to purchasing an insurance policy. If you own a house in a flood-prone area, you will want to protect this asset from the risk of flooding – to cover it, in other words – by purchasing flood insurance. In this example, you cannot prevent a flood, but you can work in advance to mitigate the dangers if and when a flood occurs. There is a risk-reward tradeoff inherent in coverage; while reducing the potential risk, it also reduces the potential gains. Simply put, coverage is not free. In the case of the example flood insurance policy, the monthly payments add up and if the flood never occurs, the policy holder receives no payment. Yet most people would choose to take this predictable, contained loss rather than suddenly lose the roof over their heads.
In the investment world, hedging works the same way. Investors and fund managers use hedging practices to reduce and control their risk exposure. In order to adequately hedge in the investment world, various instruments must be used strategically to offset the risk of unfavorable price movements in the market. The best way to do this is to make another investment in a targeted and controlled manner. Of course, the parallels with the insurance example above are limited: in the case of flood insurance, the policyholder would be fully compensated for his loss, perhaps less a deductible. In the area of investment, hedging is both more complex and an imperfect science.
Perfect coverage is one that eliminates all risk in a position or portfolio. In other words, hedging is 100% inversely correlated to vulnerable assets. It is more of an ideal than a reality on the ground, and even the hypothetical perfect cover is not without cost. Baseline risk refers to the risk that an asset and a hedge will not move in opposite directions as expected; “base” refers to the deviation.
How does coverage work?
The most common form of hedging in the investment world is through the use of derivatives. Derivatives are securities that change in correspondence with one or more underlying assets. They include options, swaps, futures and futures. The underlying assets can be stocks, bonds, commodities, currencies, indices or interest rates. Derivatives can be effective hedges against their underlying assets, since the relationship between the two is more or less clearly defined. It is possible to use derivatives to implement a trading strategy in which a loss for an investment is mitigated or offset by a gain on a comparable derivative.
For example, if Morty buys 100 shares of Stock plc (STOCK) at $ 10 per share, he could hedge his investment by purchasing a US put option of $ 5 with an exercise price of $ 8 expiring in a year. This option gives Morty the right to sell 100 shares of STOCK for $ 8 at any time during the next year. If a year later, STOCK is trading at $ 12, Morty will not exercise the option and will be at $ 5. He is unlikely to worry, as his unrealized gain is $ 200 ($ 195, including the price of the put). If STOCK is trading at $ 0, however, Morty will exercise the option and sell his shares for $ 8, for a loss of $ 200 ($ 205 including the price of the put). Without this option, he risked losing all of his investment.
The effectiveness of derivative hedging is expressed in terms of delta, sometimes called the “hedging ratio”. Delta is the amount of the movement of a derivative per movement of $ 1 of the price of the underlying asset.
Fortunately, the different types of options and futures allow investors to hedge against most investments, including those involving stocks, interest rates, currencies, commodities, etc.
The specific hedging strategy, as well as the pricing of the hedging instruments, may depend on the risk of a fall in the underlying security against which the investor wishes to hedge. In general, the higher the downside risk, the greater the coverage. Downside risk tends to increase with higher levels of volatility and over time; an option which expires after a longer period and which is linked to a more volatile security will therefore be more expensive as a means of hedging. In the STOCK example above, the higher the strike price, the more expensive the option, but the more price protection it will offer. These variables can be adjusted to create a less expensive option that offers less protection, or a more expensive option that offers better protection. However, at some point it becomes unwise to buy additional price protection from a profitability perspective.
Hedging through diversification
The use of derivatives to cover an investment allows precise calculations of the risk, but requires a certain sophistication and often a lot of capital. Derivatives are not the only way to hedge, however. The strategic diversification of a portfolio to reduce certain risks can also be considered as hedging, although somewhat coarse. For example, Rachel could invest in a luxury goods business with increasing margins. However, she could fear that a recession would wipe out the ostentatious consumer market. One way to combat this would be to buy tobacco stocks or utilities, which tend to weather recessions well and pay big dividends.
This strategy has its tradeoffs: if wages are high and jobs plentiful, the luxury goods maker could prosper, but few investors would be drawn to boring countercyclical actions, which could fall as capital flows to places more exciting. It also involves risks: there is no guarantee that the stock of luxury goods and coverage will move in opposite directions. They could both decline due to a catastrophic event, as happened during the financial crisis, or for independent reasons, such as the floods in China that pushed up tobacco prices, while a strike in Mexico does the same for the money.
In the index space, moderate price declines are fairly common and are also very unpredictable. Investors who focus in this area may be more concerned about moderate declines than more severe declines. In these cases, a bearish sell spread is a common hedging strategy.
In this type of spread, the index investor buys a put with a higher strike price. Then he sells a put at a lower price but on the same expiration date. Depending on the behavior of the index, the investor thus has a degree of price protection equal to the difference between the two strike prices. While this is likely to be moderate protection, it is often enough to cover a brief drop in the index.
Hedging is a technique used to reduce risk, but it is important to keep in mind that almost every hedging practice will have its own drawbacks. First, as noted above, hedging is imperfect and is not a guarantee of future success, nor does it guarantee that losses will be mitigated. Investors should rather think of hedging in terms of advantages and disadvantages. Do the benefits of a particular strategy outweigh the additional expense it requires? Because hedging will rarely, if ever, result in an investor earning money, it should be remembered that successful hedging is one that only avoids losses.
Coverage and everyday investor
For most investors, hedging will never come into play in their financial activities. Many investors are unlikely to trade a derivative contract at any time. This is partly due to the fact that investors with a long-term strategy, such as retirement savers, tend to ignore the daily fluctuations of a given security. In these cases, short-term fluctuations are not critical as an investment will likely increase with the broader market.
For investors who fall into the buy-and-hold category, it may seem that there is little or no reason to inquire about coverage. However, because large companies and investment funds tend to regularly engage in hedging practices, and because these investors can follow or even be involved in these larger financial entities, it is useful to have an understanding of what coverage involves in order to better be able to follow and understand the actions of these major players.