By Ee Hsin Kok. Edited by Arjun Chandrasekar.
Hedging is a strategy employed by investors and traders in order to limit the risks of existing positions. In a sense, it is an insurance policy against adverse price movements. In this article, we go over why hedging is important, when to hedge, and how to hedge.
Asking why investors or traders hedge, is similar to asking why people buy insurance. Take a health insurance policy, for example, every month people make payments to health insurance companies that stack up to a lot over time, and if they never get hurt, they never get a payout. In fact, consumers know that the insurance company has an edge over them. They know that over a large sample size of people, the premiums paid to the insurance company will beat any payouts they have to make. And yet, people still buy insurance! Why? Because it gives them peace of mind. They’re willing to pay the premiums every month so that on the off chance they are ill, they won’t have to spend their whole life savings treating that injury or disease.
The same can be said for investors. Some investors wish to never see a 50% drawdown in their portfolio no matter what, so they hedge against that. But keep in mind, just like how insurance can be expensive over the long run, so can hedging! It protects your downside, but if nothing bad happens, it hurts your upside.
Hedging is not just for investors and traders though. Many ordinary people and businesses are naturally long or short on certain things in the market, and hence have to hedge against those natural positions. For example, farmers often have to hedge a lot! They are naturally long on their crops, and because the prices of commodities can fluctuate over time, some farmers don’t want to take the risk that a decline in prices would cause their crops to be unprofitable. So they use futures contracts in order to lock in their sale price a few months down their line. This is another form of hedging.
When and How to Hedge
It’s incredibly tough to predict when the right time to hedge is because no one knows where the market will be a day, week, or month from now. But there are certain strategies you could employ. The least costly method of hedging would be diversification. By diversifying your portfolio across different industries, you are reducing unsystematic risks such as company scandals or industry-specific crises. However, the systematic risk would still exist, and to hedge against systematic risk would be much more costly. The cheapest way to do this would be through out-of-the-money VIX call options. In the event of a large market crash, panic and fear would cause the VIX to go up, and the call options bought would even out the losses from your main investment portfolio. A more expensive method would be to buy put options on the S&P 500. In the event of a crash, these could go up a lot more than VIX options, and they have unlimited upside. However, it is only advisable to buy these when you are sure of a market downturn such as a change in trend because the time decay on put options can make it extremely expensive.
In this article, you learned what hedging is, why it is done, and how it is done. You also learned that hedging isn’t exclusive to the finance world, and is carried out by people such as farmers. Keep in mind that there are many more advanced strategies out there to hedge effectively, so don’t settle for the basics introduced to you today. Hedging (done right) can prevent a lot of losses in the long run, so make sure to do further research and explore!