Hedging is a risk management strategy where uncorrelated or low-correlation investments are grouped into a portfolio. The resulting combination of investments is intended to create more balance and lower portfolio volatility.
Investors hedge with a variety of strategies, like adding an uncorrelated stock position, buying a put option to limit downside exposure, selling options to reduce cost basis in the stock position, using a multi-leg option strategy to define a range of potential outcomes, or some combination of hedging alternatives.
The advantages of hedging stock positions include stabilizing portfolio returns and limiting downside risk. Disadvantages of hedging may include lower upside potential (due to the hedge’s cost) and the risk that the hedge does not fully protect the portfolio as expected.
Hedging typically comes at a cost. If the hedge is unnecessary--the stock position appreciates and no downside protection was required--the cost reduces the original trade's profitability.
For example, if a put option is purchased in an attempt to hedge a stock position, and the stock gains value, the cost of the put option somewhat offsets the appreciation in the stock position. In the risk/reward spectrum, if all risk is “hedged away,” virtually all potential reward will be. Thus, to hedge is to compromise.
FAQs
How do you hedge a stock position?
Hedging stock is the process of protecting one position by entering another offsetting position. The purpose of hedging is to reduce downside risk and minimize losses.
Hedging is a risk management strategy where uncorrelated or low-correlation investments are added to a portfolio. The resulting combination of investments is intended to create more balance and lower portfolio volatility.
What are some hedging strategies?
Hedging is made possible through a variety of strategies, such as adding an uncorrelated stock position, buying a put option to limit downside exposure, selling options to reduce cost basis in the stock position, using a multi-leg option strategy to define a range of potential outcomes, or some combination of hedging alternatives.
How do you hedge stocks?
Stocks can be hedged using multiple strategies such as adding an uncorrelated stock position, buying a put option to limit downside exposure, selling options to reduce cost basis in the stock position, using a multi-leg option strategy to define a range of potential outcomes, or some combination of hedging alternatives.
What is an example of hedging?
Hedging is similar to buying car insurance.
Consider, for example, a long put option. Like car insurance, the stock owner is willing to pay a premium to protect their asset against significant downside risk by defining the maximum amount they would have to pay. Put options require paying a debit but secure a price point (the strike price) at which an investor has the right to sell shares of stock. If an investor owns 100 shares of stock purchased at $50, they may choose to spend a fixed amount, say $300, to purchase a put option with a strike price of $45 that expires in 90 days.
If their underlying stock position is trading below $45 after 90 days, they have the right to exercise the put option and sell stock at $45, no matter what price the underlying stock is trading. If the stock is trading above $45, the option will expire worthless, and they can choose to purchase another put option to hedge the position for a future expiration date.
What is the best hedging strategy?
There is no perfect hedging strategy because hedging always comes at a cost. In the risk/reward spectrum, if all risk is “hedged away,” then virtually all potential reward would be as well. Thus, to hedge is to compromise.
Purchasing options will add cost to the original position. Selling options will reduce the upside profit potential. Buying uncorrelated positions has the potential for one stock to lose value while another gains value, therefore leaving the portfolio relatively neutral overall.
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