What is Hedging: Meaning and Strategies

Regardless of the investment we make, we always expose ourselves to various risks. These risks can be inflation risk, interest rate risk, currency risk, liquidity risk, market risk, etc. Each of these risks represents the possibility that we will lose money in the future.

To reduce these potential losses, there are strategies commonly called hedging.

This article will explain what hedging means. It will also look at how major financial institutions implement hedging in their day-to-day operations. But more importantly, it will also give some examples of how you can hedge your asset portfolio.

Definition and Basics of Hedging

In investment terms, hedging refers to a strategy used to reduce or mitigate the risk of adverse price movements in an asset. Essentially, it involves taking a position in a related security or asset to offset potential losses in another investment.

For example, an investor who owns a stock might hedge against the risk of a decline in its price by buying put options on that stock. If the stock price falls, the gains from the put options can offset some or all of the losses from the stock. Hedging doesn’t eliminate risk entirely, but it can help manage and control it, typically at the cost of reducing potential gains.

Let’s say you’re buying a new car. You are required by law to purchase insurance for it to cover the potential damage you cause to another driver or a pedestrian.

An insurance policy helps reduce your financial costs in the event of an accident. In effect, you insure yourself against the financial costs in the event of an accident.

In a simple definition, hedging is:

Actions taken by an individual or company in the present that are intended to reduce exposure to a possible event in the future

A car insurance policy helps you reduce the risk of major financial costs in the event of an accident.

Other simple everyday examples of hedging are:

• Taking an umbrella when we leave our house in case it starts to rain;
• Leaving home earlier to avoid traffic jams and not be late for work;
• Stopping at a red light to avoid hurting someone.

All of these actions are among the best ways to understand what hedging is and why it is so important when talking about investments.

Hedging and Investments

Just as no one would want to pay a large sum of money in an accident, no one would want to lose money on their investments.

Regardless of preparation, no one can accurately predict the price of a stock or commodity tomorrow, a week from now, or even a year from now

This lack of certainty about the future is what drives the markets. It enables the realisation of profits and the movement of capital that supports the development of certain regions or industries in the world.

Of course, financial markets also have downsides. Potential losses can turn people off. This is one of the main reasons why 42% of Americans do not invest in the stock market. But there are ways to reduce the risk of losses.

Let’s look at a few hedging strategies you can use.

1. Diversification

Perhaps the most important word in investing is diversification. This means you should never invest too much of your portfolio in a single asset.

Investing in different asset classes is beneficial in reducing potential losses. For example, to reduce the risk of losses on the stocks you own, you can invest in commodities such as gold and silver. Both precious metals are known to outperform the stock market, especially during times of economic hardship.

More on the subject here: Is gold a good investment during a crisis?

Another instrument used primarily by US investors are government bonds. This is actually how the famous “60/40” wallet appears. It refers to investing 60% of the portfolio in stocks and 40% in bonds. The problem with this portfolio is that it does not cover interest rate risk.

When central banks manipulate interest rates, the value of bonds changes rapidly. When interest rates rise, the value of existing bonds you may already own in your portfolio falls. This happens because newly issued bonds have a higher yield than current bonds.

The same thing happens with stocks. When borrowing is more expensive, people are less willing to borrow and invest it in the stock market. If you’re not actively managing your portfolio and shifting it to newer and newer bonds, you’re going to be left behind. Not to mention that bonds barely cover the rate of inflation. 

2. Long – Short Position   

A strategy widely used by hedge funds—funds that are allowed by law to invest in riskier assets with the goal of higher returns offset by market risk—is the long-short strategy.

Whenever we hear “long” in investments, it means someone is buying something. Conversely, when we hear “short” it means someone is selling something.

Let’s say you believe that the price of a stock will rise in the future. Therefore, you buy several shares, which means you are taking a long position. To offset the potential risk of a decline in the stock price, you can take a short position in the stock of another company, perhaps a competitor or in a different industry.

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In this way, not only are you hedging against the potential loss of that stock, but in the event that the price rises, due to the adoption of a new technology or a new business contract with a supplier, the competitor’s stock may fall. When the competitor’s price drops because you are short, you make money.

A similar example can be considered if you believe that the stock market is about to crash. In such a scenario, you can short the stock market and buy gold, which has historically risen in price when stocks have fallen.

3. Market – Neutral Strategy   

Similar to the previous way of reducing risk, you may decide to adopt a strategy where you take both long and short positions, but with the sole aim of breaking even.

Basically, all you want is to cover your potential loss on the asset you are long on with a relatively equal amount of capital invested in short positions on an asset that is inversely correlated.

More on the topic here: Gold vs Bitcoin: the driving forces behind their prices

To better understand the difference between this strategy and the ordinary long-short strategy, you should know that in this case the allocation is in such a way that the expected results of the two assets cancel each other out.

In the former strategy, you can go fully long on an asset driven by high certainty that the price will rise, and only partially cover your potential losses.

4. Arbitration

Another common term in the investment world is arbitrage. Arbitrage simply means buying something cheap in one place and selling it at a higher price in another place.

As an example, you buy bottles of water from a random shop, catch the train and sell them to the other passengers. Pressured by the lack of an offer, travellers will be more willing to pay more for the same bottle of water.

In finance, arbitrage can occur anywhere

From differences in exchange rates between two currency pairs, to differences in commodity prices in the spot and futures markets, to when the same stock trades on two exchanges at slightly different prices.

It is important to note that these differences are very small and are corrected within minutes by the markets. This correction is happening precisely because of the arbitrage seekers. Usually, it is very difficult for average investors to encounter such events because they are locked in by large financial institutions, mainly hedge funds.

Key Takeaways

Hedging means protecting your investments from potential risks. The most suitable option for the average investor is to diversify his portfolio. Although this would mean a lower return, the bottom line is it is much more important to be safe than to risk losing your investment.

Among the most effective investments one can make in the long run that also help hedge against market risk are investment gold and silver.