What is a hedge?

Whilst at first sounding like something you might find in a garden, in the financial sense, a hedge, or hedging definition, is a risk management method which helps investors to mitigate loss against movements in an asset’s price. Normally, a hedge consists of taking an offsetting position in a related security.

There are a whole host of hedging strategies available to investors, such as short hedges and long hedges, as well as a variety of financial derivatives, like futures, contracts and options.

Where have you heard about hedging?

The phrase “hedging your bets” is probably the first thing that comes to mind. The meaning of the expression is literally to reduce your risk. This use of the word ‘hedge’ has been in use in the English language since the 1600s. Hedging risksin finance is much the same as the old phrase. Its origins lay in the planting of actual hedges, or shrubs, that acted as a natural fence on a piece of land. In this sense, a hedge limited an area, and the concept of limiting risk arose from this same meaning.

You’ve almost certainly heard of hedge funds and other hedging strategies that show up in the news with semi-regular frequency. This is especially true in the financial pages and in particular when it comes to the large salaries and bonuses enjoyed by certain hedge fund managers.

What you need to know about hedging…

The meaning of hedging

A good analogy would be an insurance policy. For example, if you live in an area prone to forest fires, then you will probably pay for and take out insurance against that eventually. In finance, hedging risk works in much the same way. It reduces the risk in an investment portfolio. However, like the fire insurance, it isn’t free. There is a risk-reward trade-off. While hedging risk reduces the potential for loss, it also reduces potential gains. With the fire insurance, monthly payments build up over time and if the forest fire never comes, the policy holder will not receive a pay-out. The same is true with hedging. On balance of course, most people would choose the predictable, circumscribed loss that is monthly insurance pay-outs, or an investment hedge, over the chance that they may suddenly lose everything in a forest fire or a collapse in their investments.

The origins of hedging

While the practice of hedging has been around for several thousand years, the actual term “hedge fund” was coined in 1949 by Forbes magazine reporter Alfred Winslow Jones. He wrote an article where he observed that investors could make higher gains if hedging strategies were implemented as an integral part of a wider investment strategy. To prove his hypothesis, Jones created an investment partnership that incorporated two investment tools; leverage and short selling, in order to simultaneously mitigate risk and enhance returns.

Also, he used an incentive fee, which was set at 20% of the profits and he used a large amount of his own personal money in the fund to ensure that the goals of himself and his investors were aligned. Jones achieved outstanding results through his hedging strategy. Between 1962 and 1966, the fund outperformed the best mutual fund by more than 85%. Jones’ success essentially started the ball rolling on what we know today as hedge funds.

Today, hedge funds represent a significant segment of the investment management industry. It has been estimated that the market is worth more than $1 trillion with over 6,000 separate funds in existence.

Derivatives for hedging risk

Derivatives are one of the principle financial instruments used for hedging risk. Put simply, they are contracts between two parties which stipulate the price and time of when to buy or sell an underlying asset. The agreement lays out certain future specifications and will have been agreed upon previously. By doing this, both parties have at least partially protected themselves if their stock price falls. Derivatives take several forms including futures, forwards, options and swaps, to name but a few. The most commonly used are futures contracts, due to their standardisation, and easy tradability on organised exchanges.

Hedging through options

Options contracts are a form of derivative. They basically act like an insurance policy on any downturn that an investment might take. By using options, investors enjoy the upside of investing in a certain stock, whilst limiting losses that may be incurred. Using options as a hedging strategyis particularly useful for larger institutions but it can also be of benefit to the individual investor.

CFDs as a hedging tool

Contracts for Difference, or CFDs, are contracts that exist between two parties, stipulating that the seller will pay the buyer any difference in price between the value of an asset at the time the contract was signed and the current value of that asset. If there is a negative difference, the buyer will pay the seller. They are in effect a type of derivative that enables traders to take advantage of price fluctuations and mitigate risk. CFDs can be effectively used as a hedging strategy. For example, a trader holding McDonalds shares may open a short-term CFD to hedge against longer term exposure in McDonalds shares. Therefore, if the price of the shares goes down, the investor will not lose out because any losses incurred will be covered by the CFD hedge.

Short hedges vs. Long hedges

A short hedge is a strategy used to mitigate a risk that producers and manufacturers have already taken. It locks the price of their product or commodity. With a short hedge, producers hedge against an expected downturn in the price of the underlying commodity. It is a common practice in agriculture and producers often pay a premium to keep a preferred rate of sale.

Long hedge ssecure against any possible increases in price of an underlying asset. It provides some protection to the buyer by assuring a future supply with a fixed ceiling price. The advantage for a seller is that it locks in a floor price.

Hedging through diversification

Investors can also mitigate their risk through diversification. Choosing to invest in several unrelated stocks means that local fluctuations in markets will have a lower overall impact. By spreading investments in multiple industries and businesses of varying sizes, one can insulate to some degree against the risk that a decline in one investment will affect the rest of the portfolio. For example, in your diversified portfolio, your shares in Smith’s grocery store may plummet after poor sales figures, but your other investments in tech companies, oil, and paper manufacture will not be affected by this downturn.

Hedging through ETFs

Exchange traded funds, or ETFs, are effective hedging instruments for those who want to lessen the effects of volatility in the markets on their investment portfolio. They are traded much like stocks. An ETF contains assets (e.g. commodities, stocks, or bonds) and they usually operate along with a mechanism that is designed to minimise fluctuations in price and keep it trading close to its net value. Usually, ETFs track an index and are attractive to investors because of their tax efficiency and relative low cost. By the end of 2015, there were over 1,800 ETFs covering nearly every market sector. Due to being publicly traded, they can be sold short, which makes them great as part of a hedging strategy.

Find out more about hedging…

Option Alpha has produced an interesting podcast covering  a variety of hedging strategies that can be used to protect your investments.