Hedging is a way for investors to protect themselves from significant loss as it can offset or minimize the chance that the assets will lose value. All investors should be familiar with the practice because portfolio protection is often just as valuable as portfolio growth and appreciation.

Hedging Strategies

Individual investors, corporations, and portfolio managers use hedging strategies to reduce their exposure to risks. To hedge against risk, investors make offsetting trades in securities with negative correlations; in other words, if one investment goes south, the other investment helps to balance out that loss. The goal of hedging isn’t to make money; it’s simply to protect against loss. 

Diversification

One method of hedging is diversifying portfolios. Owning a variety of assets whose values don’t rise and fall in conjunction with one another means that if one asset collapses, the investor won’t lose everything. Many individual investors will purchase bonds to offset the risk they take in buying stocks. The value of corporate bonds and U.S. Treasurys increase as stock prices fall.

Derivatives

Hedging often involves using financial instruments known as derivatives, the two most common being options and futures.

Investors can hedge by purchasing a put option. Put options make it permissible for the option holder to sell a specified amount of an asset at a given price called the strike price. The strike price is so-called because the investor will presumably strike or sell when the stock price falls to that value or lower. While put option holders are not obligated to sell, it gives them that right if they choose. Many assets such as stocks, commodities, indexes, and currencies have put options available. It’s essential to be aware that put options do expire. 

When it comes to commodities, hedging often involves futures contracts. A futures contract is a legal agreement that obliges buyers to purchase (or the seller to sell) the commodity at a set price at the contract’s expiration. Futures are frequently used to hedge the price fluctuation of the underlying asset and prevent the investor from losing out if the price change is unfavorable; however, there is a downside to these contracts. If the underlying commodity price goes down throughout the contract, it can force the buyer to purchase at a higher rate than the going market value, thus losing money.

What It Means for Investors

It’s essential to keep in mind that any form of risk prevention in investing doesn’t come without a cost. Those utilizing put options pay a premium for the option to sell if things go south. Those buying futures contracts face potential losses if the market price of the commodity falls. Investors must determine for themselves whether the benefits are worth the expense.