The term hedging is one of the most confusing financial topics but it’s one every investor should understand. Let’s take a look at what hedging is, how it works, and what hedging techniques investors and companies use.
It’s like insurance.
When people hedge, they are protecting themselves against the impact of a negative event. You do this every day. You buy homeowner’s insurance to hedge against fire, car insurance to hedge against a collision, and so on. Negative events can still happen, but the damage done to your personal finances is lessened because you bought insurance.
In financial markets, hedging is more complicated than buying insurance. Hedging against investment risk requires strategic use of instruments in the market to offset the risk of any adverse price movements. Essentially, investors hedge their investments by making new ones. The technique is implemented not so much to make money but to reduce potential loss.
So how do you do it?
Hedging generally involves the use of complicated financial instruments called derivatives, which are securities whose prices are dependent upon or derived from one or more underlying assets. The two most common derivatives are options and futures. How derivatives work is complicated but basically these instruments allow you develop trading strategies where a loss in one investment is offset by a gain in a derivative.
For example, say you own shares of a bread company. You believe in this company’s long-term potential but are currently worried about volatility in the wheat market that could mean short-term losses for the bread company. To protect yourself, you can buy a put option (derivative) on the company which gives you the right to sell your bread company shares at a specific (strike) price. This is called married put. If your stock price falls below your strike price, these losses will be offset by gains in the put option.
Why do companies do it?
There are 3 common ways companies use derivatives for hedging, all of which protect their investments:
- Foreign-Exchange Risks - to mitigate the risk that a change in currency exchange rates will adversely impact business results.
- Hedging Interest-Rate Risk - to mitigate the risk of changing interest rates.
- Commodity or Product Input Hedge - to mitigate the risk of price changes on raw-materials or commodities. Companies that depend heavily on raw-material inputs (airlines, for example) would seek to hedge their investments against steep price increases of those raw materials (like crude oil).
Hedging, whether in your personal or business portfolio, is about decreasing or transferring risk. It’s a valid strategy designed to protect you and your money. Be sure to discuss this and other protection strategies with your financial advisor at your next meeting.