Quick Summary: Traders will hedge a bet in order to reduce the risk associated with the initial position they have taken up. This normally means placing a bet in the opposite direction to their original bet, occasionally in the form of a futures contract. A hedge bet won’t necessarily cover the entire cost of a lost bet, however it will cover some of the loss made on a trader’s original position.
Full Overview: Whether you’re new to the world of trading or an experienced trader, hedging provides an efficient and cost-effective way to minimise market risks and offset or reduce losses.
The practice of hedging became more popular with the rise of hedge funds in the last century, and an increasing number of traders and investors are using hedge strategies on a daily basis to protect their investments.
Even though hedging can be fairly simple, many market participants still don’t understand how to properly hedge their positions against known market risks. Here, we’re going to give an overview of what hedging is and how to use it to protect your trading capital.
What is a Hedge?
A hedge is simply an investment that is designed to offset or limit the risks of another investment. You can simply think of hedging as an insurance policy – A hedge limits losses of your open positions and preserves your trading capital, making it an important part of overall risk management in the markets.
It’s important to note that hedging can’t avoid all losses, but if done and implemented properly, it can significantly reduce the most common risks of financial markets, including industry risks, trading correlated instruments, currency risks, inflation risks, and political risks, to name a few.
Traders and investors use various financial instruments and derivatives to hedge their active positions and offset the risk of adverse price movements. This includes other negatively-correlated instruments, call and put options, futures contracts, bonds, and commodities.
How to Hedge?
Traders and investors hedge an active position by taking trades in other instruments that are designed to offset the underlying risks. For example, let’s say you’ve bought stocks ABC but are worried that a market correction might be just around the corner which would send the price of your stocks down.
Instead of closing your long, you could buy a put option that gives you the right (but not the obligation) to sell stocks ABC if their price falls below a pre-specified price level. This way, you could still make a profit if your market views were wrong and the bull run continued, but are protected by the option contract against negative downside moves. We’ll dig deeper into hedging with options later in this article.
Before we move on with different hedging strategies, it’s important to fully understand the concept of correlation and positively/negatively correlated assets. After all, hedging is a technique that involves using negatively-correlated instruments to offset the risks of an active position.
In statistics, correlation shows to what extent a pair of different variables move together, i.e. are related. Correlations between two variables are described using the correlation coefficient, which can have a value between -1 and +1. The correlation coefficient measures the strength of the relationship between the variables. The closer the coefficient is to -1 or +1, the stronger the relationship between the two variables.
A correlation coefficient of -1 describes a perfectly negative correlation between two variables: If one variable (e.g. financial instrument) goes up by one tick, the negatively-correlated variable will go down by one tick by the same amount. Perfect negative correlations are almost non-existent in financial markets.
A correlation coefficient of +1 describes a perfectly positive correlation between two variables: When one variable goes up, the other variable goes up as well by the same amount. Just like in the case of perfect negative correlations, it’s hard to find perfect positive correlations in the market.
Most financial instruments have a correlation coefficient of between -1 and +1. Since all financial markets are interconnected, all financial instruments will exhibit some degree of correlation. A correlation coefficient of 0 means there is no relationship between two variables, i.e. their moves aren’t related in any form.
In hedging, you should be interested in financial instruments that have a negative correlation coefficient, i.e. they should move most of the time in different directions. A simple example of negatively correlated instruments is the Indian rupee and oil. Since India is heavily dependent on oil imports, higher oil prices often lead to a fall in value in the Indian currency. When one variable rises or falls, the negatively-correlated variable takes the opposite direction.
Hedging Industry Risks
Now, let’s go into more detail on how to use a hedge to offset or limit various risks when trading.
An important hedging strategy involves hedging against industry risks.
For instance, imagine you’re long a stock of a large oil-producing company. You like the company’s management and news also shows that the company is investing in new technologies that should make drilling easier and more cost-effective. However, you’re worried that global demand for oil may fall in the coming months, pushing the price of oil down and negatively affecting oil companies.
To offset that industry risk, you could simply go short in the stock of a major competitor. If your market view proves correct, you would likely lose in your long position but make a profit in the short position you took in the major competitor. This way, you would be able to offset part of your initial losses with the gains made in the short position.
If your market view was wrong and oil was trading higher, your initial long position would likely return a profit and your hedge (the short in the competitor) a loss. Bear in mind this important concept: While hedging reduces and offsets downside risks, it also limits your profit potential. Always weigh the cost of a hedge against its potential advantages when placing a hedge.
Hedging with Derivatives
A popular way to hedge against negative price movements is by using derivative contracts. A derivative contract is a contract that derives its value from an underlying financial instrument. Derivative contracts include options, futures, and CFDs (Contracts for Difference), for example.
Let’s take our trader who’s long in the oil industry as an example again. A trader is long in a major oil-producing company because he believes in the company’s management and future projects. However, he’s worried about the negative impact of lower global oil demand in the coming months.
To hedge his long position and limit losses of a possible bear market in oil, the trader could buy put options for a small fee, called the option premium. Let’s say his long position is currently in profit: He bought the stocks at $50 and they currently trade at $75. By buying a put option with a strike price of $60, he would have the right (but not the obligation) to sell his stocks at $60, no matter the current market price.
Therefore, by paying the option premium, our trader would be able to limit his losses (and actually make a small profit) on his long position.
Hedging Currency Risks
Currency risk is another important reason why traders, investors, and corporations hedge in the financial markets.
Currency risk arises due to volatility in currency exchange rates. Currencies fluctuate on a daily basis and are influenced by a number of reasons, such as changes in interest rates, technical levels, investor positioning, and sentiment, to name a few. Corporations are known to hedge currency risks by building entirely new production lines in foreign countries, for example. This makes their cost basis denominated in the foreign currency, eliminating or significantly reducing currency risk.
While this might be an effective way to hedge currency risk for large multinational corporations, there are also easier ways that can help individual traders and investors to limit their losses on investments denominated in foreign currencies. For example, let’s say our trader who’s long in oil stocks is actually based in Europe, but the traded oil company is located in the United States. Changes in the EUR/USD exchange rate can have a substantial impact on potential profits or losses for our trader, so a smart decision would be to hedge the currency risk.
Since his stocks are traded in US dollars, a large fall in the value of the US dollar would negatively impact his performance in euros, his domestic currency. Our trader could hedge his position by buying call options on EUR/USD for example, capping the exchange rate in case of a significant rise in the EUR/USD exchange rate (when EUR/USD rises, this is bearish for the US dollar.) Just like with other hedging strategies, buying call options comes with a cost – the option premium. The hedging insurance will reduce his total profits by the cost of the option, but he would be insured against negative exchange rate movements in the US dollar.
Another way to hedge currency risks is to trade directly on the spot FX. Our trader could go long EUR/USD, which would offset exchange rate losses in the stock position with profits in the spot FX position in case the US dollar falls in value. Again, bear in mind that a fall in the EUR/USD exchange rate (a rising US dollar) would increase profits in the stock position but lead to a losing position in EUR/USD.
Hedging Against Economic and Political Turmoil
A popular hedge is to insure against unfavourable political events and economic slowdown by investing into safe-havens. Safe-havens tend to rise in times when investors avoid taking risks in the market, also known as low risk appetite or risk-averse market conditions. When economic growth shows signs of an upcoming recession or political events threaten positive risk appetite, investors tend to sell risky, high-yielding assets in favour of more stable low-yielding ones. The resulting capital flows lead to higher prices of low-yielding safe havens as a result.
Take the 2008-09 financial crisis and the US dollar index for example. A trader who was long equities at that time could hedge his position by simply buying US dollars. When equities fall, investors who’re cashing out are pushing up the demand for US dollars, which in turn leads to a rise in the currency’s value.
Here’s a chart of the relationship between the US dollar index (US dollar vs. a basket of currencies) and the S&P 500. Notice how the USD index rises while equities fall and vice-versa in the 2008-2010 period.
Other popular choices for hedging against political turmoil and global economic slowdown include buying the Japanese yen, Swiss franc, and gold. These are major currencies of developed economies with a stable and positive trade balance, which makes them ideal safe-havens when risk sentiment shifts from risk-on to risk-off.
Diversification is a natural way to diversify a portfolio of investments by mixing a number of uncorrelated instruments. A well-diversified portfolio shouldn’t have high exposure to any particular asset class, which in turn limits market risk compared to holding a single stock or asset class.
When a trader or investor diversifies a portfolio, unsystematic risks of any single position should be smoothed out by the performance of other instruments inside the portfolio. In other words, the negative performance of some investments is neutralised by the positive performance of other investments inside the same portfolio. To take the most advantage of portfolio diversification, individual asset classes and instruments shouldn’t have a high positive correlation.
Empirical evidence shows that a portfolio of 20-30 individual stocks can significantly limit and offset market risk compared to holding a couple of stocks. Similarly, a well-diversified portfolio should also include other asset classes, such as bonds, commodities, and cash, for example.
Pros and Cons of Hedging
To summarise this article, here’re a few key takeaways and the main pros and cons of hedging:
- Hedging allows to offset and limit losses of other investments
- A well-implemented hedge allows you to preserve your trading capital when prices move against you
- Traders can hedge positions of any size and over any timeframe
- Most of the time, hedging is not free – It’s like a paid insurance policy
- While a hedge can limit losses, it also limits the potential profits of an investment
- A good hedge involves taking a position in negatively-correlated instruments. Bear in mind that correlations can change over time.