One way to think about hedging is to consider it like insurance. When people hedge, they’re essentially insuring themselves against an event that could be costly to them. So, although hedging doesn’t prevent the negative event from occurring, it does help lessen the impact if something occurs.
Hedging In The Financial Sense
Hedging in the financial sense means that an investor has protected him or herself against a loss via a price movement of an asset. And, it’s the reason why so many professional options traders have been able to survive and profit over the long term. Therefore, hedging can be considered the placement of “insurance” into a financial portfolio so as to offset certain unfavorable price moves.
In the most basic sense, hedging is the purchase of a new stock that could rise as much as the current stocks fall. Therefore, if an investor owned shares of ABC stock and they were profiting from this investment, but they wanted to protect that profit in the case that ABC shares fall, the investor could purchase DEF stock which could rise $1 if ABC falls $1.
Hedging With Options
The truth, however, it’s nearly impossible to hedge stocks with other stocks.But it’s easy to hedge stocks using stock options. Many investors don’t consider using options to help them in reducing risk with other types of investments. This may be because options have been thought to be risky investments in and of themselves. However, the truth is that options can be a great way to hedge against risk and to even eliminate risk in certain cases.
Utilizing A Put Option
One way to accomplish this is through the use of a put option. This is particularly helpful if an investor is holding a significant amount of equity in one or only a few select stocks. In this case, the investor could suffer a heavy loss if the share price of just one of these stocks begins to fall. Here the investor can purchase a put option that will allow him or her to sell a specific stock at a set price on or before a certain time, or expiration date. Thus, should the price of the stock begin to fall, the investor has now “locked in” a specific sell price. This helps to avoid losing any additional funds should the price of the underlying stock drop below the strike price of the put option. So for example, if an investor owns 1,000 shares of ABC stock, they can “insure” those shares at a strike price that is at or close to a price that they wouldn’t lose any money if they had to sell the shares – as long as they’re able to do so if needed on or prior to the expiration date of the option.
Utilizing Protective Puts
A second way to utilize options this way is by using protective puts. In this scenario, an investor would be hedging against a drastic drop in an underlying stock by buying a put option. Thus, if the underlying stock price fell, the investor could still sell off their stock at the put’s strike price. This reduces the risk taken purchasing the underlying.
Utilizing Covered Calls
A third way is through the use of covered calls. Here the investor would hedge against a slight drop in the price of an underlying stock by selling call options. The premium that the investor receives from the sale of those call options will serve to buffer against the drop in the underlying stock’s share price.
Utilizing A Covered Call Collar
A final way to hedge stocks by using options is to use a strategy called a covered call collar. In this case, the investor is hedging against a slight drop in the price of the underlying stock by writing put options. Here the investor is simultaneously increasing profitability of holding the stock that he/she believes to be in a range in a specific time frame by writing call options.
In any of these cases of hedging, it’s important to understand what exactly the biggest risk in the portfolio is. This allows you to determine the best option strategy with which to hedge the investment properly. It’s also important to keep in mind that there’s a risk and return tradeoff to this hedging. For example, a reduction in risk will typically mean a corresponding reduction in potential profits. Therefore, hedging shouldn’t be viewed as a way to profit, but simply a way in which to reduce potential loss. As a result, prior to using a hedge to protect investments, you must ask yourself if the benefits that will be gained from the hedge will justify the potential loss in profit that may have been gained if you didn’t sell the underlying asset at a certain price.