Hedging is the process of managing trades solely to mitigate the risk of loss due to market fluctuations. For example, selling & buying of EUR/USD if the trend is reversed.
How a Hedge Works
Using a hedge is somewhat analogous to taking out an insurance policy. If you own a home in a flood-prone area, you will want to protect that asset from the risk of flooding—to hedge it, in other words—by taking out flood insurance. In this example, you cannot prevent a flood, but you can plan ahead of time to mitigate the dangers in the event that a flood occurs.
There is a risk-reward tradeoff inherent in hedging; while it reduces potential risk, it also chips away at potential gains. Put simply, hedging isn’t free. In the case of the flood insurance policy example, the monthly payments add up, and if the flood never comes, the policyholder receives no payout. Still, most people would choose to take that predictable, circumscribed loss rather than suddenly lose the roof over their heads.
In the investment world, hedging works in the same way. Investors and money managers use hedging practices to reduce and control their exposure to risks. To appropriately hedge in the investment world, one must use various instruments in a strategic fashion to offset the risk of adverse price movements in the market. The best way to do this is to make another investment in a targeted and controlled way. Of course, the parallels with the insurance example above are limited: In the case of flood insurance, the policyholder would be completely compensated for her loss, perhaps less of a deductible. In the investment space, hedging is both more complex and an imperfect science.
Hedging Through Diversification
Using derivatives to hedge an investment enables precise calculations of risk, but it requires a measure of sophistication and often quite a bit of capital. However, derivatives are not the only way to hedge. Strategically diversifying a portfolio to reduce certain risks can also be considered a hedge, albeit a somewhat crude one. For example, Rachel might invest in a luxury goods company with rising margins. She might worry, though, that a recession could wipe out the market for conspicuous consumption. One way to combat that would be to buy tobacco stocks or utilities, which tend to weather recessions well and pay hefty dividends.
This strategy has its tradeoffs: If wages are high and jobs are plentiful, the luxury goods maker might thrive, but few investors would be attracted to boring countercyclical stocks, which might fall as capital flows to more exciting places. It also has its risks: There is no guarantee that the luxury goods stock and the hedge will move in opposite directions. They could both drop due to one catastrophic event, as happened during the financial crisis, or for two unrelated reasons.
In the index space, moderate price declines are quite common and highly unpredictable. Investors focusing on this area may be more concerned with moderate declines than with more severe ones. In these cases, a bear put spread is a common hedging strategy.
In this type of spread, the index investor buys a put that has a higher strike price. Next, she sells a put with a lower strike price but the same expiration date. Depending on how the index behaves, the investor thus has a degree of price protection equal to the difference between the two strike prices (minus the cost). While this is likely to be a moderate amount of protection, it is often sufficient to cover a brief downturn in the index.
Risks of Hedging
Hedging is a technique used to reduce risk, but it’s important to keep in mind that nearly every hedging practice will have its own downsides. First, as indicated above, hedging is imperfect and is not a guarantee of future success, nor does it ensure that any losses will be mitigated. Rather, investors should think of hedging in terms of pros and cons.