As promised here is some background and insight around hedging-incidentally as I surmised the markets took a turn down yesterday and the QQQQ Puts I bought have already increased by just under 20% in one day.I cannot say if this is the beginning of a correction but I am glad I have some downside protection.Hedging is a little discussed but very important tool for investors.It may sound like an outdoor activity involving shears and ladders but it can be the difference between poor and great returns
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.
How does this work in Practice
Say you have bought shares in Google(Goog) you believe that they are a good long term bet but you want to protect yourself from any potential downside in the short term.You would buy a number of PUT options in Google to protect you should they fall below a certain price-say $450.
Every put option is worth 100 shares so if you owned 200 shares you would need to buy 2 PUT options.If the share price fell below the $450 then your PUT options would increase in value to protect and minimise the losses.(This is a reasonably simplistic explanation as there are a no of other factors at play here but this is the general principle behind using Options to Hedge)
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.