If you’re not incredibly familiar with the ins and outs of investing, there are several terms you may hear in financial conversations that might throw you for a loop. One such term is “hedging” — even though it may sound like an activity better suited for those involved in gardening or landscaping, it’s an essential practice in the world of stock market investing.

However, like most financial terms and phrases, hedging can’t be explained in only one or two sentences! This article will provide you with an overview of hedging against risk in the stock market so you can be a more intelligent and successful investor. Keep reading to learn more.

What Does it Mean to Hedge Against Risk?

You can think of hedging as a type of insurance. When you decide to hedge, you’re ensuring that your finances will not be negatively impacted by a particular event. However, it doesn’t prevent all adverse events from occurring. Instead, it ensures that if the adverse event happens, while you’re properly hedged, you won’t get impacted by it as much.  

We all hedge against risk every day. For example, when you pay insurance for your house, you’re hedging yourself against potential natural disasters, fires, or even break-ins. And when we insure our own health, we’re doing the same; we’re preparing for some bad outcomes that we don’t want to be significantly impacted by. 

Hedging Against Risk in Investing

When it comes to the world of finance, portfolio managers, corporations, and individual investors all use different hedging techniques to reduce the likelihood of them being impacted by a wide range of risks. In the climate of the stock market, hedging is not as straightforward or as simple as paying a fee to an insurance company and getting yearly coverage. 

When we talk about hedging against investment risk, we essentially mean using financial instruments and different market strategies to offset some of the risks you may face due to other movements in the market. To simplify, investors often hedge one of their investments by trading in another. 

However, in order to hedge, you’re required to make offsetting trades in securities, which have a negative correlation. Unfortunately, this means you still have to pay for this kind of insurance in one way or another. For example, let’s say you have long shares of company X; you can buy a put option to protect that investment from big downward moves. However, in order to purchase that option, you will have to pay the option premium.

A reduction in risk almost always comes with a reduction in potential profits, and so hedging is mainly considered to be a technique for reducing potential losses. If the investment you’re hedging against has positive returns, you’re losing the money you invested in your hedging strategy. But, if that same investment loses money, then your hedge was on point and helped reduce your losses. 

How to Hedge Your Stock Portfolio

As we already mentioned in the previous paragraph, hedging an investment is a lot more complicated than simply paying an insurance company for one year and forgetting all about it. There are a variety of ways to hedge stock. Below, we will be discussing ways to hedge using options and some other approaches for portfolio hedging.

Before we get started, let’s first clarify what an option is — basically, an option contract is an agreement that gives its buyer the right to either buy or sell a specific asset at a specific price. However, options can either be executed at any time prior to the expiry date or only on the expiry date, and that’s something you always need to consider. With that out of the way, let’s take a look at three ways to do portfolio hedging.

Diversifying Your Portfolio 

One of the best ways to hedge a portfolio, in the long run, is by ensuring that it’s a diverse one. That includes holding assets in different industries that are not tightly or at all correlated. That way, the overall volatility of your portfolio is decreased. No matter what kind of changes occur in the market, a diverse portfolio of assets will suffer lower average losses, and so it’s the easiest way to ensure you have some sort of security. 

Having Both Long and Short Put Positions 

This is often called a put spread, and it consists of you having both long and short put positions. Here, for instance, you can buy a put option with a strike price at 85% of the spot price and sell a put with a 75% strike. The sale of the put will help offset part of the cost of the put you purchased. However, if you follow this example, the portfolio will only be hedged if the market goes down from 85% to 75% — if it falls lower, then the gains on the long put will be offset by all the losses in the short one.

Buy a Put Option, Sell a Call on the S&P 500 Index

This action is called a “collar” on the stock market, and in order to do it, you need to purchase one put option and then sell a call one. In this scenario, by selling a call option, you’re earning some—or most—of the money required to buy the put option. And so, if the index rises above the call option strike price, the call option will bring in losses, which the other gains in the portfolio will offset.

Buy the strongest company, Sell the weaker one.

This hedging strategy is a classic long-short strategy.. It involves investing in the strongest company in a given sector and selling short the weakest. This way in theory at least if there is a general economic or specific sector sell-off, the stronger company’s losses that you have a long position in will be more than offset by the weaker companies’ greater losses.

Of course, this is analogous to a parlay in betting.  The odds are greater and the potential payoff is greater by predicting two winners instead of just one. In other words, you have to be right about your long investment as well as your short investment. Just like in traditional betting, the challenge is greater.

Are There Any Disadvantages to Hedging Against Risk?

You need to remember that hedging is always a trade-off. There’s almost always a cost, and there are no guarantees that your hedge will do what it was set out to do. A serious hedging risk can arise if the instruments used for hedging a portfolio are mismatched. However, constructing a hedging strategy that entirely matches a portfolio is often very difficult (and expensive), so mismatches are often accepted. 

Along with that, hedging stocks should be done once or twice per year if you want it to be done well and bring you positives. That’s because if the market rises after you implement a hedge, then the new gains won’t be protected. Additionally, as time goes on, options may begin to decrease in value as their expiration date approaches. Options are valued based on market prices, and these prices can fluctuate depending on market forces, so they can increase portfolio volatility even if they protect their ultimate value.

The Difference Between Hedging, Speculation, and Diversification

Hedging, speculation, and diversification are all activities that are related to investing and are often used when people discuss the moves they make on the stock market.  In this case, it will be easy to understand the difference because these terms are relatively distinct from one another. 

Speculation is an activity that aims to use the changing price of a security in order to make a profit, and both hedging and diversification are on the other end of the spectrum. The idea of hedging is to reduce the amount of risk associated with the change in a security’s price, and diversification aims to reduce the overall risk you take on with your portfolio. 

To put it simply, speculation is a strategy that uses the fluctuations in the market to make you more money and is high-risk, high-reward. At the same time, hedging and diversification are strategies that are aimed at helping secure your current gains against market volatility and ensure that your portfolio takes on less risk. 

The Bottom Line

Whether you plan on becoming an active investor or you’re just thinking about putting some of your savings into an investment portfolio, knowing what hedging is and why it’s useful is vital. Hopefully, this article helped you learn more about what it means to hedge against risk and gave insight into a few strategies that are frequently implemented.

If you’re having trouble managing your portfolio or you want to get some in-depth insight from a Certified Financial Planner, you can contact us at Alpha Wealth Funds — we will be more than happy to assist you.

Please feel free to reach out to me on this or any of your investment needs or questions. I may not always have the answers at my fingertips, but I promise I will get them for you. Harvey Sax

Founded in 2010, our services include boutique hedge funds, separately managed accounts, financial planning, estate & trust services, private placements, and in-house concierge services for high net worth individuals, families, and businesses.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. All investments involve risk including the loss of principal.