Although
it sounds like it might be the hobby of your neighbor obsessed with
his topiary garden full of tall bushes shaped like giraffes and dinosaurs,
hedging is a practice every investor should know about--there is no
arguing that portfolio protection is often just as important as portfolio
appreciation. Like your neighbor's obsession, however, hedging is talked
about more than it is explained, making it seem as though it belongs
only to the most esoteric financial realms. Well, even if you are a
beginner, you can learn what hedging is, how it works, and what hedging
techniques investors and companies use to protect themselves.
What
is Hedging?
The best way to understand hedging is to think of it as insurance. When
people decide to hedge, they are insuring themselves against a negative
event. This doesn't prevent a negative event from happening, but if
it does happen and you're properly hedged, the impact of the event is
reduced. So, hedging occurs almost everywhere, and we see it everyday.
For example, if you buy house insurance, you are hedging yourself against
fires, break-ins, or other unforeseen disasters.
Portfolio managers, individual investors, and corporations use hedging
techniques to reduce their exposure to various risks. In financial markets,
however, hedging becomes more complicated than simply paying an insurance
company a fee every year. Hedging against investment risk means strategically
using instruments in the market to offset the risk of any adverse price
movements. In other words, investors hedge one investment by making
another. Technically, to hedge you would invest in two securities with
negative correlations. Of course, nothing in this world is free, so
you still have to pay for this type of "insurance" in one
form or another.
Although some of us may fantasize about a world where profit potentials
are limitless but also risk free, hedging can't help us escape that
hard reality of the risk-return tradeoff. A reduction in risk will always
mean a reduction in potential profits. So, hedging, for the most part,
is a technique not by which you will make money but by which you can
reduce potential loss. If the investment you are hedging against makes
money, you will have typically reduced the profit that you could have
made, and if the investment loses money, your hedge, if successful,
will reduce that loss.
How Do Investors Hedge?
For the most part, hedging techniques involve using complicated financial
instruments known as derivatives, the two most common of which are options
and futures. We're not going to get into the nitty-gritty of describing
how these instruments work, but for now just keep in mind that with
these instruments you can develop trading strategies where a loss in
one investment is offset by a gain in a derivative.
Let's see how this works with an example:
Say you
own shares of Cory's Tequila Corporation (Ticker: CTC). Although you
believe in this company for the long-run, you are a little worried about
some short-term losses in the Tequila industry. To protect yourself
from a fall in CTC you can buy a put option (a derivative) on the company,
which gives you the right to sell CTC at a specific price (strike price).
This strategy is known as a "married put." If your stock price
tumbles below the strike price, these losses will be offset by gains
in the put option. (Again, we aren't going to get into too much detail
here, but if you'd like to learn more see our article on married puts
or our options basics tutorial.)
The other
classic hedging example involves a company that depends on a certain
commodity. Let's say Cory's Tequila Corporation is worried about the
volatility in the price of agave, the plant used to make tequila. The
company would be in deep trouble if the price of agave were to skyrocket,
which would eat into profit margins severely. To protect (hedge) against
the uncertainty of agave prices, CTC can buy a futures contract that
allows the company to buy the agave at a certain price. Now CTC can
budget without worrying about the fluctuating commodity. If the agave
skyrockets above that price specified by the futures contract, the hedge
will have paid off because CTC will save money by paying the lower price.
However, if the price goes down, CTC is still obligated to pay the price
in the contract and actually would have been better off not hedging.
Keep
in mind that because there are so many different types of options and
futures contracts an investor can hedge against nearly anything, whether
a stock, commodity price, interest rate, or currency.
The
Downside
Every hedge has a cost, so before you decide to use hedging, you must
ask yourself if the benefits received from it justify the expense. Remember,
the goal of hedging isn't to make money but to protect from losses.
The cost of the hedge--whether it is the cost of an option or lost profits
from being on the wrong side of a futures contract--cannot be avoided.
This is the price you have to pay to avoid uncertainty.
We've
been comparing hedging versus insurance, but we should emphasize that
insurance is far more precise than hedging. With insurance, you are
completely compensated for your loss (usually minus a deductible). Hedging
a portfolio isn't a perfect science and things can go wrong. Although
risk managers are always aiming for "the perfect hedge," it
is difficult to achieve in practice.
What
Hedging Means to You
The majority of investors will never trade a derivative contract in
their life. In fact most buy-and-hold investors ignore short-term fluctuation
altogether. For these investors there is little point in engaging in
hedging because they let their investments grow with the overall market.
So why learn about hedging?
Even
if you never hedge for your own portfolio you should understand how
it works because many big companies and investment funds will hedge
in some form. Oil companies, for example, might hedge against the price
of oil while an international mutual fund might hedge against fluctuations
in foreign-exchange rates. An understanding of hedging will help you
to comprehend and analyze these investments.
Conclusion
Because risk is an essential yet precarious element of investing, you
should, regardless of what kind of investor you are, gain a fairly good
awareness of how investors and companies work to protect themselves.
Whether or not you decide to start practicing these intricate uses of
derivatives, learning about how hedging works will help advance your
understanding the market, which will always help you be a better investor.
