With fluctuations in the stock market, investors are often left with a loss of profit. A hedge is a tool used by investors to reduce and eliminate risk of price movements on assets.
Employing hedge movements can offset the probability of losing value on assets. By using a hedge strategy in a portfolio, you have the chance to protect profits made, reverse or stop losses, and protect an entire portfolio.
How Does Hedging Work?
While there is downward stock market trends that cannot be stopped, hedging is a tool that can lessen the damage. Hedging investments eliminate and limit risks that affect holding in a portfolio. When employing hedging we are taking on another cost to keep assets safe.
What Is an Example of a Hedge?
The best way to explain a hedge is by using the example of car insurance. When an individual purchases car insurance, they are spending money to add protection onto assets. While this doesn’t prevent accidents from happening, it does mean there is less to worry about when there is damage or a need for repairs.
While insurance requires individuals to pay set amounts each month, hedging shares is completely different.
What Is a Hedging Strategy?
Hedging is a strategy many employ to protect themselves from losing money. But, hedging is not a strategy used to grow assets. To hedge in a portfolio, you need negatively correlated shares, meaning when one increases in value, the other decreases.
For example, say you own 100 shares of XYZ and there is a belief that this stock going to decrease within the next 6 months. By buying a put option, you can hedge against the potential downward trend. The current share of XYZ is around $180 and you assume it will fall over 20% in the next 6 months. This put option can decrease the amount that is lost.
For instance, say you bought a put option with a $165 strike price and the premium cost at $8 per share. As the investor, you have the right to sell your shares at $165 until the date of expiration. While you are still out $800 due to the premium, the premium is the cost of hedging funds in the portfolio. Therefore, you lessened the damage of losing funds.
Without a hedging strategy you would have faced more loss as you sell your shares at market value. If the market price were to drop to $110, we would be out $7,000. Compared to our put option hedging strategy where we would be down only $2,300.
What Are Hedge Funds?
Hedge funds take assets from investors to ultimately decrease risk and receive a credit in return. With little regulation, there is more risk associated when entering into these pools. Typically, hedge funds are expensive, leaving many to face high fees.
While similar to mutual funds, hedge funds are heavily speculated by investors. These funds are used by investors who take long positions on undervalued securities while simultaneously taking short positions on overvalued securities. Essentially, hedging is similar to insurance. Investors employee this strategy to protect against downturns in the market.
Since hedge funds are not regulated by the SEC, many are unaware of the top hedge fund companies in operation. Those who have access to these funds are typically accredited investors. Meaning, not just anyone can seek out hedge funds to grow and protect assets in their portfolio. Hedge funds are also subject to large management and carry high interested fees on profits being made.
Example of a Hedge Fund
The best example of a hedge can be based on the world’s leading hedge fund company, Bridgewater Associates. As of January 2021, Bridgewater Associates holds over $150 billion in assets, making it the most profitable asset management company today.
What Is a Forward Hedge?
Understanding what a forward hedge is begins with understanding what a forward contract is. This contract is a risk management strategy where the buyers and sellers agree upon a set price and set day to buy or sell assets.
By employing contracts the buyers will have the ability to lock into a set price for particular assets. While sellers will have the ability to lock into a set price to sell particular assets. This strategy is very common between businesses and individuals who want to determine cash flow throughout the year.
Using this strategy means buyers and sellers are not at risk from the fluctuating prices on the market. Although, the downside of using the strategy means that if prices drop sellers miss out on opportunity to sell their assets at a higher price. If prices drop buyers miss out on the opportunity to purchase assets at lower prices.
What Hedging Means for You
So, what does hedging mean for you? With a large or small portfolio, incorporating hedging into investments can help you decrease risk and even diversify your overall portfolio.
Hedging is beneficial and useful too to minimize loss potentials. Using hedging will allow you to keep most of your assets safe. There is still a cost to employ hedging whether that is through hedge fund managers or possibly premiums when using options trading. Finding your strategy should always be looked at before taking a hit from the downward market trends.
Benefits of Hedging
There are numerous benefits to hedging in the stock market.
Potential to make money: By using a hedge strategy in a long term portfolio, risk will be more contained. Loss generated will be lessened and can even be calculated to set amounts.
Lock into profit: Investors have the ability to set profit at certain prices. Hedges allow investors to know how much they will be making on positions.
Less monitoring will be needed: Using a hedge strategy helps offset the constant worry of market volatility. So sit back and relax.
Offset risk: The most important of all, risk is minimal. While there is a price to be paid to insure assets, it can be offset.
Risks of Hedging
There are many upsides to using hedging in one’s portfolio, but it’s important to keep in mind the risk associated with the concept.
Hedging sets you up for limitations on profits to be made. It requires investors to spend money on specified assets they want insured. Investors having to spend premium prices or fees, means there is less money to be received when pulling shares.
Not only that but, there is no guarantee that you have a limited downside to hedge investments. There could be larger potential profit losses that could hinder investors receiving profit at all.
How a Financial Advisor Can Help With Hedges
As we went over today, hedging is a great tool investors should employ to protect assets and even diversify their portfolio. With many upsides to hedging and hedge funds, those looking to add this tool to their portfolio should hedge the risk.
Looking to invest and add this tool to your strategy? Learn how and why speaking to a financial advisor can help you grow your portfolio.