Hedging your bets involves taking two or more opposing positions so that you can still profit even if unfavourable outcomes occur. The term 'hedging' has a similar meaning in finance, allowing you to partially eliminate certain risk factors from your portfolio.
What is hedging, and why is it a good idea?
In finance, hedging refers to buying an investment that will offset your potential losses on another investment. In many ways, it is analogous to taking out an insurance policy on your existing portfolio — if your other investments head south, your hedging investment will pay out.
For example, you can hedge against your potential losses on a share you own by buying a derivative contract called a 'put option' on the same share. The put option will increase in value if the share price drops below the contract's strike price, offsetting some of the losses you might otherwise have made on the share.
However, there are many ways to hedge against potential losses and specific risk factors. Derivative contracts like futures can help investors hedge against interest rate rises, foreign exchange and market risks, and even inflation risks.
But you don't need to buy sophisticated financial instruments like interest rate swaps, futures, or even options to hedge your risk. Many exchange-traded funds (ETFs) available to everyday investors can help offset certain risk factors.
And you can also hedge your risk by diversifying your share portfolio across different economic sectors. The share prices of companies in one industry may increase when the share prices of companies in another industry decline. If you buy shares like this – that are negatively correlated with one another – you can offset the potential losses on your portfolio.
How does it work?
As we've already mentioned, one of the most frequent ways investors choose to hedge their investments is through derivative contracts like share options. Options give you the right to buy or sell the underlying shares at a specific price within a certain period of time. An option to sell shares is called a 'put' option, and an option to buy shares is a 'call' option.
To illustrate how options can be used to hedge your losses, consider the following example.
Let's say you bought 100 shares in a miner like Rio Tinto Limited (ASX: RIO) for $115 apiece, but you also want to hedge your investment in case the price of iron ore falls significantly over the next few months.
At the same time you buy your Rio shares, you could also buy a put option to sell your shares for $105 each at any point within the next six months for a premium of $60.
Suppose your worst nightmares are realised, and the price of iron ore tumbles, causing the Rio share price to tank. By the time six months have passed, Rio shares are trading at just $90 each, meaning you are currently down $2,500 on your initial investment of $11,500.
However, your put option gives you the right to sell your shares for $105 instead of $90 This gives it an intrinsic value of $1,440 (after subtracting the $60 premium).
Because the $1,440 offsets against your $2,500 loss, it leaves you down just $1,060. Still a significant loss but a much better outcome than if you hadn't hedged with the put option.
Common strategies for hedging
Investors can pursue many different hedging strategies to protect themselves from severe losses. Some of the most common are listed below.
Portfolio construction
Portfolio construction aims to maximise the potential returns you can make, given your risk appetite.
To construct a prosperous and stable share portfolio, you should consider your personal investment objectives, time horizon, and risk appetite. You can then build an optimal portfolio by investing in the mix of shares and other asset classes that deliver the highest possible return without exceeding your personal risk tolerance.
Modern portfolio theory suggests that you should always consider new investments in the context of how it will impact the risk and return of your overall portfolio. Constructing an optimal portfolio involves hedging by diversifying — see below — into different stocks, sectors and asset classes to keep your overall portfolio risk within acceptable levels.
Options
We mentioned options earlier in this article. Options are derivative contracts, which means they derive their value from the value of an underlying asset, like shares. An option gives the holder the right (but not the obligation) to buy or sell the underlying asset for a given price before the contract's expiration date.
The most common way to hedge using options is to buy put options. They effectively limit your downside risk from a share purchase.
Diversification
Diversifying your portfolio is an excellent way for everyday investors to hedge against potential losses. It doesn't require any fancy derivative contracts or financial expertise — instead, you just need to spread your investments over multiple different shares or asset classes, particularly those whose price movements aren't correlated with one another.
Different companies respond to macroeconomic events in different ways. For example, rising interest rates might be good for banks and insurance companies but could decrease consumer spending and hurt retail companies' share prices. If you had owned shares in both banks and retailers, the losses on your retail investments might be at least partially offset by gains made on your banking and insurance shares.
If you expand this to cover multiple different shares — and not just retail and bank shares — you can see how diversifying can reduce your overall portfolio volatility. The losses you experience in some areas of your portfolio will be offset by gains elsewhere, smoothing your returns. A well-diversified portfolio will still increase in value over time as the value of the overall market increases, but you won't experience as many bumps along the way.
Short-selling
Short-selling is when you borrow a specific number of shares to sell on the open market and then repurchase them at the end of the loan period.
If the market price of the shares has declined, you can now repurchase the shares at the lower price and return them to the lender. You pocket the difference between what you earned from selling the shares and what you paid to buy them back again.
Short-selling is a common hedging strategy because it allows you to still profit when the price of a share declines. Investors may take a combination of short and long positions in their portfolio to hedge against potential losses.
It can be difficult — and risky — for everyday investors to participate in the short-selling of individual shares. However, purchasing units in 'inverse' ETFs is an easy alternative. These are funds designed to be negatively correlated with the returns of their underlying index.
This means that when the benchmark's price rises, the price of the inverse ETF will decrease, and when the price of the benchmark falls, the price of the EFT will rise. As with most hedges, an inverse ETF might help offset your losses in a falling market, but it also dampens your potential upside.
And more…
There are plenty of other ways investors hedge their positions, some of which are highly technical and involve purchasing combinations of different options.
In the United States, buying units in ETFs that track the volatility index or VIX is possible. Also known as the 'fear index', the VIX increases when share prices are volatile. An investment like this can help add stability to your portfolio when the prices of your other shares are seesawing.
Drawbacks to hedging
The main drawback to hedging is that you may miss out on potential returns. When you purchase put options to limit your potential losses on other shares you own, you still have to pay the option premium whether or not you end up exercising the options. This can eat into your upside if your shares increase in value and you do not need the options.
Diversifying your investments, particularly into financial instruments like inverse ETFs, may also dampen your potential returns. If the prices of your other investments increase, it's likely that the price of the inverse ETF will fall, meaning you won't have made the same level of gains as if you hadn't bought the ETF in the first place.
However, hedging is all about controlling risk. Although it may cost you some upside, hedging strategies are important to keep in mind when constructing a strong and stable share portfolio that will allow you to grow your wealth safely and securely over time.
