Investing involves the risk of loss. But it is possible to hedge, or reduce, some of the risk of loss. Here's what you need to know about hedging stock positions with options and other investments.
What is hedging?
Hedging is an advanced risk management strategy that involves buying or selling an investment to potentially help reduce the risk of loss of an existing position. Hedging is not a commonly used trading strategy among individual investors, and in the instances where it is used, it is typically implemented at some point after an initial investment is made. That is, you would not hedge a position at the outset of buying or shorting a stock.
Let's look at a hypothetical hedging example. Suppose you purchased 100 shares of XYZ stock at $30 per share in January. Several months later, the stock is trading at $25. Assume that you do not want to sell the stock (perhaps because you still think it might increase over time and you don't want to incur a taxable event), but you want to reduce your exposure to further losses. To hedge this position, you might consider a protective put strategy—purchasing put options on a share-for-share basis on the same stock. Puts grant the right, but not the obligation, to sell the stock at a given price, within a specified time period. Suppose you purchased put options sufficient to hedge your existing position with a strike price of $20. In this scenario, you would be protected from additional losses below $20 (for the duration of owning the put option). You can learn more about trading options here.
What are some reasons for hedging?
The primary motivation to hedge is to mitigate potential losses for an existing trade in the event that it moves in the opposite direction than what you want it to. Assuming you think your trade will go in the opposite direction than what you want over some period of time, there can be a variety of reasons why you may want to hedge rather than close it out, including:
- Overconcentration. You may have significant exposure to a specific investment (e.g., company stock) and you want to hedge some of the risk.
- Tax implications. You may not want to have a taxable event created by selling a position.
Unrelated to individual investors, hedging done by companies can help provide greater certainty of future costs. A common example of this type of hedging is airlines buying oil futures several months ahead. Airlines hedge costs, in large part, so that they are better able to budget future expenses. Without hedging, airline operators would have significant exposure to volatility in oil price changes.
What investments are used to hedge?
Hedging can involve a variety of strategies, but is most commonly done with options, futures, and other derivatives. Indeed, options are the most common investment that individual investors use to hedge. Note that the trading of options and futures requires the execution of a separate options/futures trading agreement and is subject to certain qualification requirements.
The trade-off for hedging is the cost of entering into another position and possibly losing out on some of the potential appreciation of the underlying position due to the hedge.
Should you hedge?
For many businesses and professional investors, hedging can be an important tool to help meet their objectives—particularly for those that have the necessary resources (e.g., employees with the skill and experience needed to understand and execute hedges). But it's important to know that hedging can be a double-edged sword—specifically, if the investment used to hedge loses value or it negates the benefit of the underlying increasing in value.
For individual investors, hedging may not be the best course of action—for several reasons:
- Complexity. Hedging typically involves advanced investment vehicles (relative to traditional investments, such as stocks and bonds). You would need to fully understand the hedging instrument in order to consider utilizing hedging. And even then, it may not be suitable.
- Cost. Hedging involves additional costs. Taking on another position (such as buying options) involves a cost.
- Effectiveness. Hedging may not be effective, even if it is implemented as intended by the hedger. Consider the example of an airline that hedges airline jet fuel costs, only for future jet fuel to be less expensive after the hedge is implemented. Also consider an investor that purchases a diversified mutual fund or ETF: If you believe that components of the fund may be exposed to the risk of loss, you may not be able to easily hedge only those components of the fund.
- Suitability. Hedging may not make sense for long-term investors. For example, suppose you purchase a stock with the intention of owning it over the long term (i.e., more than a year). After a couple months, you believe the stock may be exposed to the risk of loss over the short term. Hedging that risk exposure may not make sense, due to the costs involved with hedging, if your intention is to hold the stock over the long term.
Consequently, you may want to manage your investments so that you have a diversified mix that aligns with your investing objectives and risk constraints. Diversification can help protect you against the idiosyncratic risks of individual stocks. While diversification does not guarantee against a loss, it is likely the more effective risk management tool compared with hedging for most regular investors.