One of the most common questions beginning traders (and even some experienced traders) ask on a regular basis is this: What is a hedge?
For the uninformed, it’s not the leafy green shrubbery that separates your property from your neighbors. In finance, a hedge is a financial position you set up in your investments to offset a big loss (or gain) that you could incur in your portfolio.
For example, let’s say that you have some positions in stocks that benefit if the stock market rises – but you want to protect yourself if the stock market goes the opposite way and falls. To create a simple hedge, you could do a variety of things, such as taking up short positions on your stocks (that deliver returns if your stock falls) or investing in bonds (which largely rise in value if the stock market falls).
Without the hedge, your loss could be bigger than you’d prefer. With the hedge, you have a loss that is far more sustainable – and in some cases, you could even come out ahead. (This is the theory behind hedge funds that devote themselves to making money by creating hedge positions.)
Two common ways to hedge involve futures and options. Here, we’ll talk about how that works with each one and what benefits they have for you.
Hedging With Futures
A future (short for futures contract) is a contract that calls for payment of a certain asset at a certain price to be delivered at a certain date in the future. It’s essentially a way to “lock in” a price now and potentially benefit later if the price rises.
For example, if you have a futures contract for 100 shares of Exxon Mobil (XOM) at $80 per share today, with an expiration date two weeks from now, you will profit if the price of XOM is above $80 when the contract expires. If it is, say, $85, you gain $5 per share for a profit of $500. This is because even though the price may be $85 when you actually pay for your shares on the expiration date, you only have to pay $80 because that was in the terms of your contract.
It’s like telling a farmer, “Hey, I’ll buy that small watermelon today for $5. I’ll pay you a month from now,” thinking that the watermelon will grow larger in a month and be worth much more than $5. If you come back a month later and it’s a huge melon, you’ll purchase a $10 watermelon for just $5. (Or the watermelon stays small because of drought and you pay $5 for a $2 melon.)
Hedging with futures is about reducing risk. Southwest Airlines made a killing a few years back because it predicted that gas prices would rise. So, the company locked in much-lower prices for jet fuel to power its fleet of airplanes. Sure enough, jet fuel rose dramatically in price – which badly hurt every other major airline except for Southwest, which saved millions.
Hedging With Options
An option is similar to a future in that it gives you control over an asset without paying for it up front (other than a relatively-small fee called the premium). The big difference is that you don’t have to honor the terms of the options contract. That’s why it’s called an option – buying (or selling) your asset at the expiration date is optional.
So, if you bought a call option for XOM (meaning you expect XOM to rise in value) at $80 and the price drops to $75 at expiry, you can choose to not buy the shares. If you did buy 100 shares at that price, you’d lose $5 per share for a total loss of $500, plus your premium (which is lost whether you buy the shares or not).
Options are most commonly used to protect gains in the event of a downturn in the market. Many traders, when using this strategy, aren’t really trying to make money off the option; they’re trying to limit the downside. This is called a protective put (since a put is a call to sell the asset and is used by people who have assets).
Let’s say that you own 1,000 shares of XOM that you originally purchased at $80. XOM is trading now at $85 per share, which means you have an on-paper profit of $5,000. You want to protect your gain. So, you decide to buy put options for a price level of $84. You pay a premium, and then you have the right (but not the obligation) to sell your shares if the price of XOM reaches $84.
If it does, then you’ll avoid losing more than $1,000 of your profit. If it doesn’t, and keeps going up, you can just let your put options expire or sell them and buy new options at a higher price to lock in even greater profit.
In this way, hedging with options is like buying insurance for your stock’s value.
When Should You Hedge?
If you have long positions that are up, hedging is a good option. Or, if you anticipate bad news ahead for your stock, you can hedge to avoid losing all your profit and then some. You should also hedge if you have one asset that forms a huge chunk of your investment portfolio. Or, if you can’t sell your stock – say, you aren’t vested in your stock shares that you received from your employer – hedging is a good idea until your shares are available.