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.
There are multiple ways to hedge a position and different reasons for hedging. 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 protect the downside risk and limit risk exposure to a defined dollar amount or percentage of the portfolio.
Hedging can be accomplished using derivatives like options and futures contracts or through similar, 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.
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 should increase in value.
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. However, a balanced and diversified portfolio is considered an effective way to hedge multiple positions.
Hedge funds specialize in hedging opportunities. Hedge funds offer an investment vehicle with low market correlation to improve diversification and risk-management.