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What is hedging? | Stock Option Hedge Example

Answers to the key questions traders are asking themselves: What is hedging? When should I hedge a position? And how do I apply this concept to my own portfolio?

With the recent re-emergence of volatility in global financial markets, the concept of hedging has never been more relevant. For experienced traders, this means reappraising and expanding their understanding of the concept and their ability to apply it flexibly, and for rookie traders, this means brushing up on the basics.

What is hedging in simple terms?

Most fundamentally, ‘hedging’ is a method of removing risk. Whilst this can never be achieved completely – and, in fact, this would be undesirable, because with zero risk there could only ever be zero reward – traders must choose which risks they are happy to be exposed to, and which they would rather minimise.

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Starting with a clear definition…

Hedging means that the decline in value of one investment is matched or offset by a rise in the value of another investment.

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It is likely that the rise in the value of the second investment isn’t quite enough to totally balance against the loss in value of the first investment, but nonetheless, the rise is useful because it covers at least some of the initial loss.

What is hedging in stocks?

In the stock market, hedging means beginning to think of your portfolio as not just as a collection of stocks or other assets, but as a group of ‘paired’ investments. 

The pairing needs to work so that the rise in one investment is matched to another investments’ fall. This can involve ownership of the assets themselves – e.g. owning stocks, or bonds, or real estate – or it can be achieved via the use of financial derivatives e.g. futures and options contracts.

We will talk more about the uses of derivatives contracts later, but we begin with a simple example of hedging through owning two stocks.

Let’s imagine that an investor feels the long-term impact of the pandemic is to push ever more people to switch to online shopping. They can express this view by buying shares in, say, Amazon, or any other e-commerce company. However, they may want to cover themselves against the risk that their viewpoint is too simplistic and ignores the fact that many consumers still value face-to-face service.

If this view is correct, then the high-street won’t decline and disappear but is set for a post-pandemic comeback. Therefore, they can hedge their original position by buying shares in UK grocer J Sainsbury, as well as shares in Amazon. If the Amazon trade is already in a profit, then the Sainsbury's trade can be used as a way of hedging profit. 

 

Source: FlowBank / TradingView

 

This way, the investor has some exposure to online and offline retailers and whichever view of the future of shopping turns out to be more correct, assuming retail sales keep rising, some part of their portfolio should have benefited.

Types of hedging

The above example is a simple version of hedging used by stock investors, where one stock is paired up with another stock that can be expected to rise in value under conditions that might be negative for the first stock.

A more advanced form of hedging involves using financial derivatives known as ‘options’ and ‘futures’ contracts. Hedging can be done in any asset class and for different purposes, such as forex hedging and interest rate hedging.

A hedging example with options

An options contract is an agreement between a buyer and a seller to complete a transaction at a fixed price in the future over a fixed time period.

Let’s assume you are interested in airline stocks because you feel that the Covid restrictions which have blighted the industry over the past two years are gradually reducing, and therefore demand for air travel is set to rise.

This is a perfectly logical and reasonable position to take, but it is not without risk. What if another Covid variant leads to another wave of lockdowns? What if many consumers are still too cautious to travel internationally so soon after the pandemic? Maybe incomes have suffered due to Covid, and therefore demand for holidays will be cut back on in favour of spending on other cheaper goods and services?

You conclude that whilst you do want to go ahead with your investment into some particular airline stocks, you also want to hedge your position to protect yourselves from the possibility that all airline stocks will decline.

One way to do this is by purchasing an option to sell either the individual stocks you have bought or an index covering a group of similar stocks such as the ‘Dow Jones U.S. Travel & Tourism Total Stock Market Index’.

An option that gives you the right to sell a stock index is known as a put option. Put options move in the opposite direction to the underlying stock- creating the hedge you are looking for.

 

Source: Optiontradingtips.com

 

The cost of buying the put option is known as the ‘premium’ and will normally be a much smaller amount than the purchase of the underlying stocks. The cost of the premium is also normally much cheaper than would be needed to 'go short' the stocks.

Buying the put option on the index, while simultaneously buying the underlying stocks means that if the value of the companies in this sector falls, you can recoup some (or all) of your losses incurred by the stocks with the short position in the options contract.

This is known as a ‘long/short’ hedged strategy, because you are going ‘long’ with a stock and hoping it will rise over time, while selling short a correlated derivative to cover your risk that the first asset doesn’t rise as expected.

Hedging with futures contracts

An alternative to buying a put option on an index of stocks is to go short a futures contract of the index. The difference is that whilst an options contract gives the option to buy or sell in the future at a predetermined price, under a futures contract both buyer and seller are committing to definitely making the transaction. Hedging with futures contracts is arguably less flexible than with options, but the idea works in exactly the same way as the above example. Of course hedging is not contrained to stock index futures and similar maneoures could be done with anything from gold to wheat 

Extra FAQ: What is a hedge fund?

Now we have a better understanding of what exactly hedging is, we can move on to discuss so-called hedge funds. These are investment funds that are actively managed with the goal of beating the average return available from the main markets. The name comes from what the funds were originally intended to do, which is to sell stocks short in order to hedge the risk of going long in other investments. This is the ‘long/short’ strategy described above.

Hedge funds are known as alternative investments and due to the high-risk strategies employed will often be riskier than standard investments (despite the name!). Hedge funds are well-known for seeking market-beating returns with ever riskier investment strategies, although hedged bets on market moves do form a certain part of how they aim to generate these returns.

 

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