How do you hedge a trade?

There are multiple ways to hedge a position and different reasons for hedging.

A hedge uses one position to help offset the risk of another position in a portfolio. If a position is showing an unrealized gain, a hedge may be used to secure profits at a specific price level. If an investor is afraid of losing money on an investment, a hedge could be put in place to contain the downside risk and limit risk exposure to a defined dollar amount or percentage of the portfolio.

Hedging can be accomplished by using derivatives like options and futures contracts or through the purchase of uncorrelated or negatively correlated instruments as the original position. The purpose of hedging is not to make money, and hedging comes at a compromise of profit.

Utilizing a hedging strategy can help reduce the overall risk of a portfolio and control market exposure. Hedges do not guarantee that a loss will be avoided. It is nearly impossible to find a perfect hedge that minimizes all potential risks without forfeiting some or all potential profit.

What is an example of hedging?

A balanced and diversified portfolio is considered an effective way to hedge multiple positions.

Hedging can be accomplished using derivatives like options and futures contracts or through the purchase of uncorrelated or negatively correlated instruments as the original position.

For example, if a stock is owned in the technology sector, an investor could short another stock in the same sector with a similar beta. This way, if the original position declines in price, the hedged position may experience a profit.

If an investor owns SPY shares, a SPY put option can be purchased to limit the position’s downside risk.

A negatively correlated position may also be opened as a hedging device. For example, two tickers that have historically performed opposite of one another could be purchased simultaneously, so that if one asset declines in value, the other asset may increase in value. 

How to hedge with options?

Utilizing a hedging strategy can help reduce the overall risk of a portfolio and control market exposure.

Consider, for example, the purchase of a put option in conjunction with owning the put option’s underlying asset. Buying a put option is similar to buying insurance for an asset. The owner of an asset is willing to pay money-- the put option’s premium--to help protect the overall investment from adverse situations, even if doing so increases the original position’s cost basis.

For example, if an investor purchased a stock at $100 and wants to protect themselves from a sharp decline, a put option may be purchased with a strike price of $90. Should the underlying stock fall below $90 on or before the options contract’s expiration date, the option holder would have the right to sell their shares of stock at $90.

Many other options strategies may be utilized to hedge a position, such as a collar or covered call, to name a few. A collar is a less expensive way to limit a position’s downside, though it limits the profit potential. A covered call strategy could be used to reduce the position’s cost basis, though it provides no significant downside protection.