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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Examples of stock hedges
An investor has an outsized allocation to Apple (AAPL +0.44%) stock. They’re concerned that the technology giant could miss expectations when it reports earnings next month, potentially causing a meaningful decline in the share price.
They hedge against this risk by purchasing a put option that expires in 60 days. With shares recently around $190 apiece, they buy a single contract (100 shares) at a $190 strike price for $6 per share ($600 total). If shares of Apple decline significantly by expiration (more than $6 per share), the put would gain value, and the investor can sell it for a profit. However, if shares don’t fall by more than the purchase premium, the hedge would lose money and could expire worthless.
A recent retiree wants to hedge some of their market exposure to protect against a major sell-off. They purchase enough ProShares Short S&P 500 ETF shares to cover a meaningful portion of their portfolio. If the stock market gains value, that hedge will eat into their returns because the ETF would lose value, and the investor is paying a relatively high ETF expense ratio of 0.89%. However, if the market meaningfully declines, they can sell the inverse ETF at a profit and use the proceeds to buy the dip in the market.
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