Investing involves risk. Without risk, you can't reasonably expect investments to generate good returns. But that doesn't mean that you have to accept the full amount of risk from a particular investment. Instead, you can use hedging strategies to transfer some of that risk onto speculators who are willing to take it on in the hopes of earning even better returns.
There are many different ways to hedge against investment risk, with some methods applying only to certain types of investments. Nevertheless, what each of these hedging strategies share in common is that they can help you reduce the amount of losses you suffer from adverse outcomes, often with minimal cost. Below, we'll look at some of the instruments you can use for hedging purposes.
1. Buying put options
If you own a stock, the biggest risk is that it can go down in value. Theoretically, a stock can drop to $0, wiping out your entire investment. That rarely happens among well-established companies, but even top blue-chip companies occasionally go through rough periods where they'll lose half or more of their value over an extended period of time.
Buying put options lets you determine how much risk of loss you're willing to endure. A put option gives you the right to sell shares of a given stock for a pre-set price between now and the option's expiration date. The investor who sells you the put option agrees to pay that price and buy your stock if you choose to exercise the option. In general, the higher the price is at which the parties agree to trade the shares, the more you'll have to pay for the option, but the less risk you'll have.
For example, looking at one popular tech stock that trades at about $190 per share, you could buy a put option that would give you the right to sell 100 shares at $180 per share anytime between now and mid-July for $1.92 per share, or a total of $192. If the stock stayed above $180 between now and then, then you won't need to exercise the option, and you'll simply lose your $192. But if the price dropped to $170, then you'd exercise and get $180 instead. In other words, by paying the $1.92 per share now, you'd limit your potential risk of loss to $10 per share. If the loss would amount to more than that, then you'd exercise the option.
By contrast, if you wanted to eliminate all risk of loss on your stock position, a put option with a strike price of $190 instead of $180 would cost you $5.45 per share. Because you can always lose the entire amount you spend on the put option if the stock doesn't end up falling below the agreed-upon strike price, it's important not to hedge to a greater extent than you really need.
Options are available from most stock brokerage companies. You'll need to complete a separate set of disclosure forms, but most brokers will gladly let you do simple hedging strategies like buying put options.
2. Futures contracts
Futures contracts also offer hedging opportunities. Initially, futures contracts centered on commodities like corn and wheat, so farmers would sell futures contracts to hedge against the chance that prices would fall by the time they harvested their crop, while food processing companies would buy futures contracts to hedge against the chance of prices rising over the same timeframe. With the advent of financial futures, however, futures-based hedging moved beyond commodities and into stock, bond, and other financial markets.
Now, you can hedge against all kinds of risks, including adverse movements in popular indexes like the S&P 500, foreign currencies, interest rates, and even new assets like cryptocurrencies. Futures trading is sometimes available with regular brokers, but some don't offer it, requiring that you get a specialized futures account.
3. Investing in a competitor
Sometimes, you don't need to make an investment that will necessarily move in the opposite direction from the risk you want to hedge. You can get some hedging benefits from making investments in multiple players in a given industry. Doing so won't eliminate the risk that the entire industry has in common, but it will address the risk that the company whose stock you currently own turns out not to be the winner in that industry.
As an example, say that you hold shares in a major U.S. airline. You think that it's likely to thrive both because the industry as a whole is healthy and because that particular airline has competitive advantages over its peers. However, you acknowledge that your stock also has unique risks that some of its competitors don't have.
If you want to hedge your airline position, you could buy shares of the most attractive competing airline. Several outcomes could result:
- If the entire industry does well, then both stocks could go up.
- If it turns out that your fear about the first airline were warranted, a rise in the second airline's stock could offset losses for the first one.
- If something happens to hurt the entire industry, both stocks could fall.
Finally, if you're wrong about the hedge, then the second airline you picked could underperform the one you already owned.
As you can see, this isn't a perfect process. But it has the advantage of diversifying your portfolio at the same time that it protects against a company-specific risk, and that appeals to many stock investors.
Hedge if you need to
For most investors, the risks involved in investing are part of what helps them earn the returns they want, and so hedging isn't necessary or warranted. But if you want to invest in something that's riskier than you feel comfortable taking on by itself, using a hedging strategy can give you the exposure you want at a risk level you're willing to endure.