Hedging a stock helps reduce risk by taking an offsetting position. Investors have many ways to hedge their portfolio, including shorting stocks, buying an inverse exchange-traded fund, or using options. While hedging can reduce risk, it comes at a cost.
What is a stock hedge?
A stock hedge is an asset or investment used to offset an existing position to reduce risk. Investors use hedges to reduce the risk of a particular stock or their entire portfolio. A hedge usually involves taking the opposite position in a similar investment or using financial derivatives like options to limit the potential impact of an unfavorable price movement in the underlying investment.
Options
What are some drawbacks of a stock hedge?
While stock hedges can be beneficial, they also have some drawbacks. Stock hedges are similar to insurance because they provide investors with downside protection. However, like insurance, stock hedges come with a cost in exchange for risk reduction.
That cost can come in many forms, including an upfront expense, ongoing fees, or reduced return. For example, buying a put option to hedge against a decline in a particular stock costs money. While that insurance premium can pay off if there’s a significant decline, the cost of setting up a series of puts to protect specific stocks can add up.
Shorting also costs money. While a short sale initially brings in cash, investors often must pay a recurring fee to borrow shares. Further, if the underlying stock or index used to hedge increases in value, the short seller would pay more money to close their short position than they initially received.
These costs impact returns in the long run. That’s why most investors limit their hedging to periods when they believe there’s a higher risk of a significant downward move in a stock or market index.
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