What is hedging?
A hedge is an investment made with the intention of reducing the risk of negative price movements in an asset. Normally, a hedge consists of taking an opposite position in a related security. In other words, you bet on falling prices and rising prices at the same time.
Hedging is therefore a strategy that aims to limit the risks of financial products. The strategy is therefore comparable to taking out insurance. Although this insurance reduces the risk, it also reduces the profit, as insurance is usually not free. In order to protect yourself appropriately in the world of investments, you need to use various instruments strategically to offset the risk of unfavorable price movements on the market. The best way to do this is to make another investment in a targeted and controlled manner.
Derivatives are one type of hedge in the investment world. Derivatives are securities that move in line with one or more underlying assets. These include options, swaps, futures and forward contracts. The underlying assets can be shares, bonds, commodities, currencies, indices or interest rates. Derivatives can be an effective hedge against their underlying assets, as the relationship between the two is more or less clearly defined. Derivatives can be used to build a trading strategy in which a loss on one investment is mitigated or offset by a gain on a comparable derivative.
For example, if an investor buys 50 shares in a company for CHF 50 per share, he could hedge the investment by buying an American put option with an exercise price of CHF 40 and a term of one year. The option gives the right to sell 50 of these shares for CHF 40 at any time in the next year. Let’s assume the option costs CHF 10 per share, i.e. the premium for 50 shares is CHF 500. If the share is traded at CHF 60 a year later, the option will not be exercised. However, the investor has also made a profit of CHF 500, as the price of the 50 shares has risen by CHF 10 per share. At this point, the investor has therefore neither gained nor lost. However, if the share price falls to CHF 30, for example, the investor can exercise the option. The investor therefore sells his 50 shares for CHF 40, thus reducing the loss.
For most investors, hedging will never play a role in their financial activities. It is unlikely that many investors will trade a derivative at any point in time. This is partly because investors with a long-term strategy, such as people saving for their retirement, tend to ignore the day-to-day fluctuations of a particular security. In these cases, short-term fluctuations are insignificant, as an investment is likely to grow with the overall market.
For investors who fall into the “buy and hold” category, there may be little or no reason to concern themselves with hedging. However, as large companies and investment funds tend to hedge on a regular basis and these investors follow the performance of these larger financial companies or even have a stake in them, it is useful to know what hedging means in order to better follow and understand the actions of these larger players.
Further examples of hedging strategies
In addition to derivatives, there are other hedging strategies. Investors should not use just one strategy, but several to achieve the best results. Below are some of the hedging strategies that investors can consider. In addition, spread hedging is explained, which is another example of hedging with derivatives.
What is spread hedging?
Moderate price declines are common in the indices. In this case, a bear put spread is a good hedging strategy. The index investor buys a put (put option) with a higher strike price. He then sells a put with a lower strike price, with the same expiry date as the put he bought. This procedure enables price protection (difference between the two exercise prices). The protection only applies within the scope of the difference, which is sufficient for moderate price fluctuations.
Diversification
The saying “don’t put all your eggs in one basket” never gets old, and it makes sense in the financial sector too. Diversification means that an investor puts their money into assets that do not move in a single direction. In simple terms, this means investing in a variety of assets that are not related to each other, so that if one of these assets falls, the others can rise. For example, an investor looking to profit from the rising margins of a luxury goods company might hedge by buying tobacco stocks or utilities. A recession, for example, could affect the sales of the luxury goods company, but the recession has less of an impact on tobacco consumption as few smokers stop smoking due to a recession.
Arbitrage
Arbitrage means buying a product and immediately selling it on another market at a higher price. This allows the investor to earn small but steady profits. This strategy is most commonly used in the stock market. Let’s take the following example to illustrate. A person buys a jacket in the USA because the brand of jacket is cheaper in the USA than in Europe. The person brings the jacket back to Europe and sells it to a friend for a more expensive price.
Average decline (average down strategy)
The average down strategy involves buying more units of a particular product even though the cost or selling price of the product has fallen. Equity investors often use this strategy to hedge their investments. If the price of a share they have previously bought falls significantly, they buy more units at the lower price. If the price then rises to a point between the two purchase prices, the profits from the second purchase can offset the losses from the first.