When is Hedging a Good Idea?

Hedging is always a good investment play. And it doesn’t have to be complicated – it can be as simple as not putting all your investment eggs in one basket.

It is very difficult to think of a situation where hedging by an investor would not be a good idea. In fact, most of us make use of hedging all the time – even if we don’t invest.

Think insurance. Many of us pay out thousands of dollars a year to insure our homes, cottages, cars, our health – and our lives. By paying those premiums, we are assured of a definite outcome, for instance that our repair bills will be paid (excluding a deductible) if the car gets damaged in an accident.

Of course, hedging doesn’t provide that sort of guarantee – you just can’t buy a product that will protect you against all losses. What you can do is minimize the losses that are pretty much inevitable for any investor.

The most obvious way of hedging involves basic diversification. Smart investors won’t have everything tied up in one sector. Their portfolio will likely have cyclical stocks like industrials and commodities, holdings that move along with the ups and downs of the economy. They will also make sure their portfolio also has more defensive stocks like utilities, which deliver steady but non-spectacular returns over the years.

Now, it’s entirely possible that these moves could cost you money in that you might have had higher returns in your portfolio had you not put money into these ‘safer’ areas. But then again, you might have experienced greater losses and this is why investing professionals don’t just practice diversification – they will spend money on products to reduce risks.

This is where more esoteric products like put options and futures contracts come into play.

When you buy a put option, you have purchased the right – but not an obligation – to sell stocks, bonds or other securities at an agreed price at an agreed time. Why would you do this? Well, suppose you have stock in ABC Corp. and you’re concerned that seasonal factors could depress the stock price later in the year. The put option will let you sell that stock later in the year at a higher price if it indeed falls in value. If it doesn’t fall in value, you don’t benefit from the put. But, you have made a smart move to defend your position.

Conversely, a call option would allow you to buy the securities at a specific price at a specific time. If those seasonal factors worked in ABC’s favour, you would be able to bulk up on the company’s stock – ideally – at a lower price than what the market is demanding down the road.

You can also buy currency options which will protect you from price gyrations in foreign currencies. This is especially helpful to a multinational firm dealing in everything from euros to pounds to dollars.

Futures contracts involve both financial instruments and commodities, which include everything from wheat to frozen orange juice to crude oil and natural gas. Financial instruments would include buying S&P 500 futures.

These futures arrangements involve an agreement to buy or sell these instruments or commodities at a specific price. However, the full price is paid later and the commodity is rarely delivered. Airlines are a good example of using futures in order to protect themselves from sudden spikes in the price of fuel (and of course in this case, the commodity is delivered).

Futures are highly leveraged, with the investor putting down somewhere in the neighborhood of 10 to 20 per cent as margin.

Short selling is also a form of hedging. Essentially, you’re making a bet that a stock will go down instead of up. This is only recommended for those with cast-iron stomachs. When you hold a stock you hope will go up – known as a long position on a stock – a potential loss will only take you to zero. But a short position that goes wrong can result in massive losses because there is no telling how high a stock will go.

And of course, the classic hedging move is thought to be buying into a hedge fund. But the name is rather a misnomer. Hedging means reducing risk but hedge funds in fact are an investment partnership available only to sophisticated investors and typically use strategies involving both long and short positions on stocks. They also invest in all kinds of investments including derivatives. The downside is that many are highly leveraged, which can lead to catastrophic results as was seen during the 2008 financial crisis.

Hedging is always a good idea but the individual investor has to determine what kind of hedging is best, especially when it comes to puts, calls and short selling. But at the very least, every investor should practice the essentials of hedging that involve basic diversification. In other words, don’t put all your eggs in one basket.

4 years ago