Understanding Hedging

To hedge one security, you would need to invest in another security that has a negative correlation. Hedging, however, has its risks.

Risk is inherent in every part of our lives. In order to survive, we consciously or unconsciously put measures in place to mitigate these risks. Mitigating these risks could be as simple as having a spare tire in your trunk, leaving your house hours ahead to give room for contingencies, and so on.

However, there are levels to shielding yourself from risk. When the stakes are higher, the cost of protecting yourself from these risky elements are higher as well. It is this same concept that has been used by the insurance industry.

To give room for contingencies and to secure your valuable assets, you pay a premium to insurance companies. If you were to add all the premiums you have paid over the years, you can say the figure would increase the cost of the asset.

However, this doesn’t mean you would have been better without it. There is a cost to security.

This is the same thing hedging does for the investor.

One of the best ways to protect yourself from the possible dangers and risks of investing is hedging. Just like insurance, a hedge shields you from an unfavorable event by reducing your potential losses. It involves the purchase of an investment solely for the purpose of reducing the risk of losses from another investment.

Investors will often buy an opposite investment to do this, such as by using a put option to hedge against losses in a stock position, since a loss in the stock will be somewhat offset by a gain in the option.

As such, to hedge one security, you would need to invest in another security that has a negative correlation. For example, if you have two products – bread and butter – and it has been proven that when the price of bread increases, the price of butter reduces, you would invest in bread and also invest in butter.

That way when one is falling, the other would rise, ultimately giving you a balance at all times. By hedging against investment risk, you strategically use market instruments to offset the risk of adverse price movements.

There are different aspects of hedging to consider but the first point to note is the cost associated with hedging, which is also known as the tradeoff between risk and return.

Risk and Return: The Hedging Tradeoff

The higher the risk, the higher the return; the lower the risk, the lower the return. This is a concept that is familiar with investors and financial individuals alike. While hedging seems like it makes your life easier buy always netting off possible losses, it still helps you lower your risks.

Therefore, it reduces your expected returns or potential profits. Hedging just cannot help us escape the reality of the risk-return trade-off. As such, just as it can help you reduce your losses, it also reduces your profits.

Using our bread and butter example, assume that the price of bread doesn’t fall and it is the price of the hedged instrument, butter, that falls. Instead of getting 100% gains on bread’s rise, the value of your portfolio is reduced by butter’s fall.

Where the investment you are hedging against makes money, you reduce the profit you could have made. The simple thing is that not all securities need to be hedged – especially the ones you believe would be fine.

However, if the risk is huge, hedging would help you cut your risks. In our next article(s), we would explore how hedging works and the ways you can hedge your securities as an investor.

Written by Lawretta Egba.