What is hedging?
A hedge is an investment made to reduce the risk of a harmful price move in something you already own. Usually it means taking an offsetting position in a related security, one that tends to gain when your main holding loses.
Who hedges
Businesses hedge all the time. They do it to make costs and revenues predictable, not to make extra money.
Airlines
Lock in fuel prices months ahead, so a spike in oil does not wipe out a year's profit.
Farmers
Agree on a price for next season's crop before it is harvested, so a price collapse does not sink the farm.
Exporters
Fix exchange rates in advance, so a swing in currencies does not erase the margin on a sale.
Investors hedge for the same reason: to put a limit on how much a bad market can cost them.
Why it matters for a stock portfolio
Losses and gains are not symmetrical. The deeper the loss, the larger the gain needed just to get back to where you started.
| If a portfolio loses | It needs this gain to recover |
|---|---|
| −10% | +11.1% |
| −20% | +25.0% |
| −30% | +42.9% |
| −40% | +66.7% |
| −50% | +100.0% |
| −60% | +150.0% |
A hedge that turns a 40% loss into a 15% loss changes the recovery from a 67% gain to an 18% gain. That is often the difference between years of waiting and a few months.
There is also behavior. When markets fall hard, many investors sell near the bottom and buy back after prices have recovered. A hedge that is in place before the decline takes some of that panic out of the decision.
The trade-off
Every hedge has a cost. Sometimes it is a known amount paid up front, like the premium on an option. Sometimes it is an unknown cost paid later, like gains you give up above a cap. Good hedging is choosing which cost you would rather carry.
The airline that locks in $75 fuel is protected if oil hits $150. If oil falls to $30, it pays more than its competitors. It accepted that in exchange for certainty.
Ways investors hedge
Bonds
Could offset losses in stocks, at times, with less volatile bonds.
Diversification
Spreading money across a wide range of asset classes.
Trend following and market timing
Trying to move to cash before a bear market does its worst.
Options
Puts and calls that offset losses directly, transfer risk, and reduce overall volatility.