What Is Hedging in Finance and How Does It Work?

Investing inherently involves some level of risk, but investors never set out to lose money. That’s why after making an investment, some investors use a strategy called hedging to reduce risk and minimize potential losses. 
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Hedging is like insurance—although implementing a hedging strategy isn’t as simple as paying a monthly premium. Similar to how insurance only covers so much, a hedge doesn’t necessarily eliminate potential for loss, and hedging strategies often can’t eliminate every risk. Instead, investors can hedge against specific types of risk to maximize their returns.

What is hedging?

Hedging refers to the practice of buying a new investment to offset another investment’s risk.

Historically, farmers hedged against the risk their crops would be worthless come harvest time by locking in buyers who agreed to purchase the crop at a fixed price. If crop prices climbed, the farmer lost potential gains, but they were protected from drops in the market.

In the world of investing, hedging serves a similar purpose. Investors may use hedging to protect against risks from changes in stock or commodity prices, inflation, interest rates, and exchange rates.

How does hedging work?

Hedging can work in different ways depending on an investor’s goals and the type of hedge.

How to hedge stocks

Stock investors conventionally hedge their stock investment positions with derivatives—financial tools that derive part of their value from an underlying asset, such as a stock. Depending on the goal, the investor might use options, futures, or swap contracts.

Let’s say an investor purchased stock in a company they believe will do well in the long run. The stock has increased in value, but they don’t want to sell. However, they fear they could lose money if the stock quickly falls, and want to hedge against this short-term risk.

The investor could buy a stock option that gives them the right to sell the stock for a specific price in a specific period, also known as a “protective put” or “put hedge.” This protects the investor from short-term declines in the company’s stock price because they have a guaranteed option to sell their stock for the “strike price.”

Conventional vs. natural hedges

In addition to conventional hedges, there are “natural hedges.” Instead of purchasing a derivative, investors look for two investments that naturally move in opposite directions, or are negatively correlated.
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Perhaps an investor has a large position in a mutual fund that primarily holds stocks. The investor might buy bonds (or a bond fund) to hedge against losses, as equities and bonds tend to move in opposite directions.

Where is hedging most often used?

Hedging can require complex analysis of current investment positions and the use of intricate derivatives. As a result, most retail investors don’t employ a hedging strategy. Additionally, many retail investors purchase investments with a long time horizon, and paying for hedging strategies might not make sense. After all, someone who is investing for retirement might not be as concerned about short-term price fluctuations as active traders.

Advantages of hedging stocks

In spite of the potential drawbacks, hedging can be an important part of actively managing an investment portfolio. Investors who buy stocks and equity funds may benefit from hedging, as it can help them:

• Avoid large losses.

  Hedging can protect investors from sudden and/or large market drops. Limiting potential losses may allow investors to hold onto positions they may otherwise want to give up.

• Limit specific risks.

  An investor may worry about a specific type of risk, such as a general market decline or a new regulation that impacts an industry. By limiting their risk, they may be able to protect their overall position for a relatively low cost.
  

Although hedging can offer stability and allow investors to lock in gains, it’s generally most advantageous for active traders and short-term investors. If you have a long time horizon, you might not be concerned about short-term pullbacks because you believe in the investments’ long-term potential.

Disadvantages of hedging stocks

Hedging might help investors minimize potential losses from investing in stocks, but it’s not without its own drawbacks:

• Hard to implement.

  Investors need to know the risk they’re taking on before they can hedge against it. However, it can be difficult to calculate risks, particularly when they’re always evolving.

• Costs money.

  Hedging strategies generally cost money to implement. Investors may pay premiums to purchase options, which they won’t get back even if they don’t exercise the option. Even holding onto an opposite investment can be costly, as there’s an opportunity cost to keeping the capital tied up.

• Potential to limit profits.

  In addition to costs eating into profits, some hedging strategies place a ceiling on potential gains. There’s a risk that investors could lose out on potential profits if they’ve implemented these types of hedges.

The bottom line

Hedging allows investors to purchase protection from potential losses. Although hedging isn’t without its own risks and costs, hedging strategies may give investors more stability and certainty in their positions.

Generally, hedging is implemented by professional investors and short-term traders. Retail investors might not have the skills to use an effective hedging strategy. Plus, some hedging strategies may not make sense for investors focused on long-term returns.