How Hedging Works In The Stock Market

Hedging is one of many tools to protect a portfolio against unexpected outcomes in the market. This risk management technique acts as a financial shield, designed to offset potential losses in your portfolio by taking opposing positions in related assets. Imagine it as a form of insurance for your portfolio. Insurance, your hedge in this case, gives you more confidence to navigate the unpredictable ups and downs of the market. Like insurance though, this tactic isn’t without cost. You’ll pay an “insurance premium” to hedge your portfolio.

Understanding Hedging

The act of hedging your portfolio involves taking positions, or implementing strategies that are oppositely correlated to your core positions. You are ensuring that if an adverse event does happen, you’ll make money on the hedge to offset the loss in your core positions.

A hedge thus does not outright prevent an adverse move to your portfolio but instead aims to reduce the impact that the event has. You can think of it like car insurance. You pay monthly premiums for coverage and in the event of an accident, you’ll have some form of protection. The car insurance itself though does not mean you’ll never get into an accident.

A hedge is not thought of as a strategy to increase your profits, but rather mitigate your losses. A successful hedge makes money when your core investment loses money. An unsuccessful hedge loses money when your core investment loses money.

Example of a Futures Hedge

A practical example of hedging is known as a forward hedge. Consider a gold miner anticipating a fall in gold prices by the time they hit paydirt. To shield against this price risk, the miner can sell a six-month futures contract at the current price of gold. Let’s say that’s $2000/oz. If, after six months, the market price drops to $1950/oz, the miner benefits by selling the gold at the higher price specified in the futures contract, effectively securing a $50/oz profitable outcome.

If the future price of gold rises to say $2050/oz, the miner will have to take a loss on the futures contract of $50/oz, but will benefit from the sale of gold at a higher price. His upside has been completely capped, but his downside loss was potentially mitigated. That is a proper hedge, not used to increase profit, purely to reduce downside.

If someone is long gold miners, they can hedge the portfolio with different ratios of short positions, or even add something long but that moves inversely correlated. United States Dollars would act as a potential hedge to gold instead of outright going short some derivative of gold.

Protective Put Hedge

Another popular hedging strategy involves using options, such as a protective put. In this scenario, say you own a stock ABC at $25. You can purchase a put option with a lower strike price than the current market value at $20. This put option provides the right to sell the stock at $20, serving as a financial safety net against potential further losses. If the stock experiences a significant downturn and goes to $5, you’ll still be able to sell at $20, as long as your put has not gone past the expiration date.

The cost of this hedge would be the premium to purchase the put option. If the price of the asset never goes below $20 there is no reason to exercise the option and you would lose the value of the premium paid to purchase it. The same loss of premium would happen if you hold the option to expiration and the stock price is over $20.

VIX Volatility Hedges

When anticipating heightened broad market turbulence, investors may use VIX-based hedging to mitigate potential losses in their existing positions.

To illustrate, suppose you hold a diversified portfolio of US equities, and there are indications of an impending market downturn. To protect against potential losses, you might employ a VIX hedge. This could involve purchasing VIX call options or going long /VX futures, which gain value as the VIX rises, offsetting potential declines in the stock portfolio. It’s still important to understand the premium cost associated with this and the non linear relationship between the VIX and say the S&P500.

Unwinding a Hedge

When you close out hedging positions, it’s often known as unwinding the hedge. Unwinding becomes necessary when the conditions of the market change, or some new piece of information becomes available to the trader or portfolio manager that dramatically impacts risk profile. Hedges might be explicitly closed out, or left to expire. It really depends on the portfolio’s balance and objectives of the trade or portfolio.

Should You Hedge?

Most traders and investors don’t hedge due to the complexities it adds to the portfolio. For buy and hold investors, time is usually what flattens out the volatility curve. Ignoring short term fluctuations in price is usually the best route to let a portfolio truly grow at the same pace as the market in the long run. Remember hedging might protect your downside, but it will also cap your upside.

As traders, unless you are selling naked options, most trades do not merit a hedge. Although it is a tool to manage risk in a portfolio, traders use position size, stop losses more effectively to control downside.

Conclusion

While hedging may not be the preferred path for all investors or traders, it certainly is a concept that should be understood. Understanding the mechanic of limiting your downside will allow you to better control your risk in some situations.