Beginner’s Guide to Hedging

Wed Feb 17, 2021, 02:06 pm | by Dan Schmidt | No comments

In 2019, a St. Louis Blues fan named Scott Berry placed a $400 on his team to win the NHL championship at 250/1. At the time, the Blues were in last place and his bet was more of a fun Vegas story than an actual shot at winning big. But then something funny happened – the Blues started winning. A lot. 

Flash forward to June and the Blues have advanced all the way to the Stanley Cup Finals where they face the favored Boston Bruins. Berry’s $400 futures bet now had a real chance at paying out $100,000. The big question now was would he hedge his bet? Berry didn’t hedge and the Blues went on to upset the Bruins in a do-or-die Game 7. No pressure with $100,000 riding on a single hockey game, right? He took home the full winnings, but had the Bruins won, Berry would have been left with nothing. Hedging by placing a big bet on the Bruins would have guaranteed some profit, but Berry decided to roll the dice. 

Hedging might not be much fun when betting on sports, but it’s a crucial strategy used to limit losses in investing. By definition, hedging also means limiting the ceiling on your profits too. Deciding how and when to hedge depends on the strategy and goals of the investor, as well as the type of investment. Here’s more about the important aspects of hedging.

What is Hedging?

Hedging is a risk management strategy designed to limit losses while also accepting a lower level of maximum profit. Hedging an investment means placing another, separate trade that will profit if your initial investment securities go down. You’re betting against yourself, but limiting the range of possible outcomes.

In the example of the sports bettor above, a $25,000 bet on the Bruins at -150 would win $16,666. Placing this separate bet would guarantee him at least $16,266 in profit (subtracting the original $400 wager), but he’d also be limiting his maximum profit total to $75,000.

So how do you bet against your own investments? It’s not as cut and dry as betting on the other team like in sports, but there are still a number of different strategies and techniques investors can employ to hedge their investments. Stocks, ETFs, bonds, and even more advanced vehicles like derivatives can be hedged or used for hedging purposes. Successful hedging demands an even more detailed investment plan though – you need to make sure you’re actually removing risk in proportion to the gains you’re taking off the table.

What are Hedge Funds?

The first hedge fund was created in 1949 with the purpose of limiting investment risk by shorting stocks to hedge a long equity position. By applying leverage and shorting overvalued stocks, the A.W. Jones and Company was able to produce gains whether the market rose or fell. For all their success, the firm began charging clients a 20% fee on all trading profits – and thus the hedge fund was born.

Hedge funds today aren’t really places where investors go to hedge their investments. Most hedge funds use sophisticated trading strategies in pursuit of alpha, or returns beyond the market averages. Leverage and derivatives are often used to juice returns, so investors must understand the risk involved. Hedge funds aren’t open to the public and only accredited investors with net worth over $1M or an annual salary of $200,000 can invest.

If you want to actually hedge your investments, a hedge fund is no longer the place to turn. A registered investment advisor is probably your best bet for learning an appropriate hedging strategy.

Disadvantages of Hedging

  • Opportunity Costs – In order to hedge your investment, you need to make an opposing trade. If you want to short sell an overvalued company to hedge your long position elsewhere in the sector, you’ll need to borrow shares from your broker and eventually cover. If you purchase put options, you’ll pay the option premium. All of this not to purchase another potential winner, but to bet against your original investment. The upfront cost is also an opportunity cost when hedging.
  • Limited Profits – A perfectly designed hedge will protect against downside, but also limit gains to the upside. If the market continues to rip higher, your hedge will lose money quickly and seeds of FOMO (fear of missing out) can begin to creep in. Hedging requires a mindset as well as capital.

Advantages of Hedging

  • Downside Protection – If you’re approaching retirement age and want to continue investing in a bull market, a hedge will allow you to keep participating while also sleeping easy at night. A big loss is easier to recover from when you’re younger, so hedging really isn’t something young investors need to worry about. But if your time horizon is condensed, hedging can be an important weapon in your arsenal.
  • Peace of Mind – Hedging can provide some mental stability in volatile markets. If you know your investments are properly hedged, you don’t need to endure the stress of constantly checking the markets and sweating every 1-2% move. A well-placed hedge can allow you to lock in better than average profits while still sleeping well at night.

Hedging Strategies

  • Swaps: A swap is a derivative investment made to hedge against certain macro risk like interest rate risk, commodities risk, or exchange rate risk. Swaps are contracts between two parties, usually an investor and an institution in an over-the-counter (OTC) transaction, in which the investor swaps cash flow now for protection against currency fluctuations or defaults. Credit Default Swaps (CDS) are probably the most famous example thanks to The Big Short – Michael Burry used CDS products to bet against the housing market.
  • Caps: Caps are often used to hedge against interest rate risk. Like swaps, caps are derivatives but the cap has a strike price where the owner is paid if a certain interest rate is exceeded (ie. LIBOR over 3%). Conversely, a floor is a derivative that pays out when an interest rate is lower than the strike price.
  • Zero Cost Collars: A zero-cost collar is a complex options trading technique that protects an equity position from decline but also offsets the cost of the premium of the puts. In this strategy, a put option is purchased on a security held long while a call option is simultaneously written. The premium of the call and put options are identical, so the upfront cost of hedging the stock position is zero.

Hedging Tools

Most investors won’t need to apply complex hedging strategies like collars and swaps to their trades. However, there are a few basic tools that can be used to protect your investments from steep and sudden losses. Even if you have no plans of using these instruments, it’s worthwhile to understand how they function.

  • Short selling – Short sellers borrow shares from their broker and sell immediately at the current price. The goal is short selling is to repurchase the shares later at a lower price and pocket the difference when returning them to the broker. 
  • Buying Put Options – A protective put is an out-of-the-money put option purchased on a stock held long. If the shares decline sharply, the value of the put option will increase and offset some of the losses.
  • Futures Contracts – Hedging against commodities risk is often done with futures contracts. For example, an oil drilling company worried about a decline in crude prices could purchase a futures contract and lock in the price of oil today. This way, if the price declines before the drilling is completed, the company can offset the loss in oil profits with the profits from the futures contract.
  • ETNs – An ETN is an exchange-traded note, a derivative sold on an exchange based on a rolling series of futures contracts. ETNs are leveraged vehicles that can be used to hedge investment in the short-term, such as buying a 2x bear S&P 500 ETN to hedge against a long position in SPY. However, these vehicles are meant for short-term strategies only and degrade quickly due the constant rolling of futures contracts.

Final Thoughts

Hedging is an investment strategy designed to limit losses while protecting profits by reducing the amount of risk (and maximum gain) of a potential investment. To hedge an investment, you’ll need to make an opposing trade in another security that will rise in value if your original investment declines. Hedging is a risk management tool, but it also comes with a set of its own risks. 

Hedging requires using extra capital to make another trade, so there are opportunity costs to consider. Hedging also usually involves derivatives, which can be difficult for novice investors to use properly. An improperly-calibrated hedge could result in serious upfront costs without any of the downside protection. If you need to hedge your investments, be sure to completely understand your risk and reward parameters.