What is Hedging In Finance? Learn the Basics with Examples

Last Updated on September 8, 2023

Every investment is subject to risk. Proper risk management must always be a crucial part of your strategy when dealing with financial markets. As contemporary markets continue to develop and lead to more opportunities, so does the need for caution and effective risk management. That is where hedging comes into the picture. In this article, we will find out what hedging is in finance. We will also examine some examples of it, so you can better utilize it in your investments.

What is Hedging?

Let’s look at what hedging is when it comes to investing and finance. Hedging in finance is a strategy used by investors to insure themselves against the downside risk of an investment position. They do so by making another trade to offset possible losses. 

Essentially, the investor hedges one asset by trading in another. This limits the risk of a more substantial adverse effect on his or her finances. Of course, this does not mean that it can help the investor altogether avoid the negative impact. However, it is a viable way to minimize any losses incurred. 

Executed properly, the financial, operational, and strategic benefits of hedging can extend farther than merely avoiding financial distress. It can also open up options for the investor to preserve value and even create more over time. 

If done poorly, however, hedging can lead to a scenario where the benefits received from the offsetting asset are not nearly enough to justify the cost. This destroys more value in your portfolio than was originally at risk.

What is hedging and how does it work? Guide with Examples

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Brief History of Hedging as a Financial Concept

While there have been several references to hedging over the last couple of decades, the term “hedge fund” only dates back to 1949. That was when almost all investment strategies involved taking only long positions. Then, a Fortune magazine reporter named Alfred Winslow Jones published an article highlighting how investors could achieve higher returns. His suggestion was to implement hedging as an investment strategy. This gave birth to the Jones investing model.

To prove his hypothesis, Jones launched an investment partnership. It utilized both short selling and leverage as part of its strategy. The aim was to limit risk and enhance returns at the same time. Jones obtained exceptional results through this hedged approach. He ended up outperforming the top mutual fund at the time by over 85% net. 

This success captured the interest of high net worth individuals. They began looking into hedging and hedge funds to reap some of those profits for themselves. Over the years, the concept of hedging in finance has evolved. It even expanded to include the system by which global exchanges can perfect, improve, and preserve the integrity of commitments made in forward contracts. 

How Does Hedging Work?

Let’s look at a simple, yet very fitting analogy: someone just bought a car and decided to purchase car insurance. This does not prevent them from ever being in an accident, but it reduces the negative financial impact should an accident occur. 

Overall, it’s a significantly better outcome than not having any at all. Even if you have to pay a premium and a deductible as needed for the insurance. It is best to think of the insurance premiums as the cost of reducing the risk, not eliminating it.

That is how hedging works. Let’s say you own XYZ stocks in your portfolio because you believe the company has excellent long term potential. However, you are concerned about potential losses in the short term. One way to reduce risk would be to buy a negatively correlated asset. So you buy ABC stocks which are inversely correlated to XYZ. That way, if XYZ goes down, ABC goes up. This way, your portfolio does not take the full hit of the losses sustained by XYZ, since the rising value of ABC can offset them.

Investors use hedging when they are unsure of where the market will swing next. So pretty much all the time. Portfolio managers and large institutional investors use various techniques to reduce their exposure to various market risks. The ultimate goal, though hardly achievable, is to execute a perfect hedge, which completely eliminates your risk exposure (except for the original cost of acquiring the contract).

In What Areas Is Hedging Used In Finance?

There are asset classes that hedging is used for in practice. These include: 

• Commodities – Any traded commodity, such as energy products, agricultural products, precious metals, etc.
• Securities – Generally in the form of shares, equities, indices, and funds. Investors can purchase securities even without taking physical possession, which makes them easily tradable.
• Currencies – This covers foreign currencies and can include using one trade to hedge another. 
• Interest rate –  Hedging can also include lending and borrowing rates. 
• Weather – This covers the weather derivatives market with relatively low-risk, high-probability events. 

Examples of Hedging

Now that you have a broad idea, let’s look at some actual examples of hedging: 

Derivatives

These are securities that derive their respective values from underlying assets. Derivatives like futures and options are really great at hedging. Here’s how:

Hedging with Futures

Let’s assume you own a successful bakery. You’re very concerned about the rising price of butter that you use in your amazing pastries. You can hedge against this unpredictability by entering into a futures contract, allowing you to purchase the butter at a specific price on an agreed-upon future date.

If the price rises considerably by the contract expiry, then hedging on the futures contract will pay off. That’s because you’d be able to get the butter at the price at which you entered the futures contract, which is lower than the market price.

What happens when the price goes down is a clear representation of one of the downsides of hedging. If the cost of butter has dropped by the contract expiration date, you are once again obligated to pay the price initially set out in the contract. Meaning you would have been better off not hedging in the first place.

Essentially, hedging this way allows you to not worry about what happens to the price of butter while you’re holding the future contract.

Hedging with Options 

An options contract is not too different from a futures contract. The main difference is that in an options contract, you’re not obligated to execute the contract upon expiry. You have the option to buy or sell that asset at a future set date. 

For instance, let’s say you own Amazon (AMZN) stock. You are reasonably bullish on the company’s growth but are bearish on the e-commerce industry. What you can do to protect against downside performance in your shares is to purchase a put option on Amazon stock. This gives you the right to sell Amazon stock at a specified price, called the strike price, at an agreed later time.

That way, if the market value declines like you feared and goes down below the strike price of the option, you’ll earn some money back with the profits from the sale of the put option. That’s because it will increase in value. Alternatively, you could exercise the option. That will allow you to sell your shares at the strike price, which is now higher than the market price. 

Asset Allocation (Diversification)

“Don’t put all your eggs in one basket.” You’ve probably heard that saying over and over, and yet it never gets old. Asset allocation is when you put your finances into investments that do not move in the same direction. 

Let’s say you own stocks from private hospitals, hotels, and a chain of malls. Let’s also assume you own other assets, such as gold, agricultural commodities, and bonds. One day, an adverse event impacts the tourism industry where the hotel operates of the company you own. Because you were diversified, your portfolio will still be in good shape. The other stocks and assets in your portfolio will not be affected by the drop in the stock price of hotels since they are not related.

This way, diversification works as an effective hedging strategy to spread the risk among several asset classes. If one category of assets sustains losses, another type can offset them.

Average Down

This strategy is simple yet quite effective. It involves buying additional units of a previously bought security or product even after its market price has dropped further. This decreases the average rate at which you purchased the stock.

Assuming you bought 100 units of a stock at $50 per share, but then the price has gone down to $40 per share. Rather than wince at the loss, you decide to purchase an additional 100 units, which then brings down your average price to $45 per share. Now the price only needs to reach $45 instead of $50 for you to break even on the position.

Cost Averaging

This is an investment strategy that involves investing the same fixed amount over a long period. Investors often use cost averaging to hedge their investments in a volatile market. By putting in the same amount of money every week or month, they’re hedging against potential losses during unfavorable market conditions. 

If the price of the security declines significantly the following month, then they end up buying more units at the lower price. Conversely, if the price rises considerably, cost averaging reduces the risk of investing a lump sum of money at a time when prices may be inflated.

Staying Liquid (Cash Reserve)

This strategy is quite straightforward. Having a cash reserve is a fantastic way to hedge against potential losses in your investments. More so in times of financial uncertainty. 

Types of Hedging

There are three main types of hedging that you should know about: 

• Forward contracts — This is a non-standardized agreement to trade a particular asset at a determined price on a date agreed by two independent parties. Forward contracts are used for various types of traded assets, including currencies and commodities.
• Futures contract —  As previously mentioned, a futures contract is a standardized agreement to trade a specified asset at a determined price on a future date agreed by two independent parties. 
• Money Markets — These cover several types of financial activities relating to currencies and other operations in the money market.

There are several types of hedging strategies available today, and while there may be some overlaps, each one is notably different. Consider utilizing more than one approach so you can mix up different ones to attain the best possible results.

Risks of Hedging

For all its many benefits, hedging is not without some downsides, even as a risk-mitigation tool. These include: 

It’s Not Free

In addition to the original cost of buying the offsetting asset, there are other costs involved in hedging. For instance, if you are hedging with derivatives, you may be required to first put down a large amount of capital and pay brokerage fees. Both of these can eat into your profits. 

Might Be Unnecessary

In a well-performing market or one that is moving sideways, hedging doesn’t really offer many benefits. In those instances, there’s hardly a need to hedge. For this reason, some investors consider hedging to be an unnecessary expense.

Danger Of Hedging Against The Wrong Risks

Investors and portfolio managers can sometimes spend too much time and effort attempting to hedge risks that don’t necessarily matter to their portfolio or company’s financial health. 

Advantages and Disadvantages of Hedging

There are a number of prominent advantages to hedging your investments: such as: 

• Limits potential losses — The main upside to hedging is that it helps you limit or reduce the damage. 
• Protects profits — In addition to mitigating your losses, hedging can also help protect your profits by entering into a futures contract.
• Higher liquidity across financial markets — Hedging your investments means you’re generally trading in different markets, like stocks, derivatives, commodities, etc. 
• It can be time-saving — Long-term investors can save time by diversifying their portfolio and merely letting it ride out in the long term. This way, they do not have to spend time keeping track of or adjusting their portfolio no matter the market condition. 
• Protects against unfavorable changes — A successfully executed hedging strategy can protect a trader from commodity price changes, interest rate changes, inflation, currency exchange rate changes, and more. 

In terms of disadvantages, hedging does have a few. These include: 

• Hedging often requires good trading skills and experience. In some instances, properly hedging your investments can involve complex trade-offs and precise calculations, which can be hard for beginner traders and investors. 
• There’s a possibility of limited profits since risk and reward are often proportional — reducing risk often means reducing your profits.
• Hedging can be difficult for day traders since with short term trading, it can be extremely difficult to keep track of the market consistently.

How Can Hedging Help You?

Hedging is often discussed in broad terms making it seem like one of those concepts that are only used among the most esoteric financial realms. And then the majority of buy-and-hold investors pay no mind to short-term fluctuation altogether. In this regard, there is little point in hedging.  

So why learn about hedging, and how can it help you? Even if you do not plan on hedging your own portfolio, it is essential to understand how it works. It is a valuable tool to have in your investment arsenal. 

One day it can help you make huge profits or save you from huge losses. When used right, hedging can reduce risk and potentially increase profits.

Conclusion 

Unfortunately, market risk will always be a persistent and precarious element of investing. And so regardless of the kind of investor you aim to be, it pays to have a basic knowledge of hedging, and it’s many strategies for better awareness of protecting your portfolio.