Hedging in finance explained
Hedging is a method of reducing risk in trading by opening one or more positions that will balance an existing trade. While hedging doesn’t prevent risk completely, it can limit losses to a known amount.
Normally, the additional position would be in a market that has a negative relationship to the open trade, or on the same market in the other direction – known as a direct hedge.
Hedging is popular because it helps protect an investment portfolio from adverse movements in the market. A lot of long-term investors won’t necessarily worry about the impact of short-term declines in their assets, focusing on the longer-term trend instead. However, some investors view hedging as an opportunity to limit the impact of losses.
Performing a hedge is commonly compared to taking out insurance, in that you’d be paying an additional cost to protect yourself against a potential negative event. If the event does occur, you’d have limited your losses and if the event doesn’t happen, your profit would be capped as you’d have the cost of the ‘insurance’ to pay out of your earnings.
Why is hedging important?
Hedging is important to understand as large companies and investment firms hedge. Having a basic grasp on the process can help you to analyse their actions and implement your own strategy.
For individual traders and investors, hedging might never be a concern – a lot of people choose to just close their positions before their losses run too large or hold their positions until the market rises again.
All hedging strategies typically involve the use of derivatives – products that take their price from the underlying market, but do not involve the buying and selling of the asset in question.
Common hedging strategies include:
- Hedging with CFDs
- Hedging with futures
- Hedging with options
Hedging with CFDs
CFDs are a very popular hedging instrument due to the fact you can offset any losses against profits for tax purposes.1 But there are a lot of other benefits to the product too, such as:
- They have no expiry date, making them perfect for longer-term protection
- They’re leveraged, meaning you can open a position with just a small initial deposit. While leverage can magnify profits, it can also magnify losses – making a risk management strategy necessary
- They can be used to trade rising and falling markets, enabling you to hedge an existing long position with a short position
- They mirror the underlying market directly, so you’ll always know the relationship between your hedge and existing trade
- The position size can be easily altered to replicate your existing trade, other hedging tools often have standardised sizes that can make this more difficult
CFD hedging example
Say you owned 500 shares of company XYZ. While you believe in the company over the longer-term, you think some negative news is going to cause a decline in the short-term. You could just let the market run its course, and your shares might decline and then rise. Or, you could perform a short hedge with CFDs.
Let’s say you open a position on 500 XYZ short CFDs, giving yourself the same exposure as your existing trade. Given that CFDs are leveraged, you’d only have to pay a small deposit, rather than the full exposure.
If the price of XYZ shares did fall, you could close your trade and take the profit. You’d hope that these earnings at least mitigated some of the loss to your investment position.
However, if the price of XYZ shares increased instead, you’d make a loss on your CFD position. This CFD loss would eat into the profits your investment position would’ve earned you.
Hedging with futures
Futures contracts are another common choice, normally used by production companies to secure a price for their product. They enable you to lock in a price for a future date.
While companies will be looking to exchange the physical good, futures can also be settled in cash – which means futures can also be used for speculation.
Futures hedging example
In another example, a corn farmer is due to harvest their crop in three months’ time. In the interim period, the farmer is open to the risk that the price of corn will fall between now and the time the crop is ready.
To mitigate this risk, the farmer sells a three-month futures contract at the current market price of $7 per bushel. This would be a forward hedge.
In the three months the pass, the market price has fallen to $5 per bushel. So, the farmer can sell the corn at the new market price and buy back the short future which would’ve earned a $2 profit.
Instead of only earning a $5 per bushel profit, the farmer would now be earning the full $7 that they would’ve received three months before.
If in the three months, the price of corn had risen instead – say to $10 – the farmer would sell the crop at that price. The futures contract would’ve made a $3 loss, meaning the total profit would still be $7 per bushel.
As we can see, hedging effectively worked in limiting the losses that would’ve been incurred, but it did also cap the total profit that could be earned.
Hedging with options
An options contract gives the holder the right, but not the obligation, to buy or sell an asset on a specific expiry date, at a set price. It’s a popular hedging instrument as buying an option is limited risk – you’ll only pay the premium that it costs to open the position.
This means that your hedge can only ever eat into your profit by so much, as you can allow your position to expire worthless if the market doesn’t move as expected.
Options hedging example
Let’s say you are long shares of ABC Corp, but you think the price is going to fall in the short-term. You don’t want to close your position but want to offset the loss you’d incur. So, you decide to buy a put option to protect your position, paying a premium to do so.
If the price of ABC shares did fall, your put option would earn a profit. This profit would balance out the losses to your investment.
If the price of ABC shares rose instead, your put option could be left to expire worthless and you’d only have lost the premium you paid to open the option position. The profit to your investment would offset this payment.
Disadvantages of hedging
The main disadvantage of hedging is that it is an additional cost to you, over and above the position you already have. But if you’re employing a hedging strategy, it’s because you want to minimise your risk, not because you want to profit.
It’s also important to remember that the perfect hedge is extremely difficult to achieve. Your hedge will likely not exactly net off your existing trade but come in slightly above or below it in terms of profit or loss.