Introduction to Hedging

What is a hedge? In investing terms, a hedge is a position taken in a financial instrument whose price movement is intended to move in the opposite direction to a core asset, designed with the purpose of reducing risk and limiting losses. The hedging instrument is typically derived from the underlying asset.

Stock investors face two principal risks First, shares in the company they own may decline regardless of what happens to the economy or the stock market. This ‘stock-specific’ risk is the price an investor pays for bearing that investment opportunity. A company may perform badly due to competition or simply due to poor management. Second, the investor faces market risk or the risk that those shares owned fall in tandem with the fate of the economy or a bear market faced by the stock market at large.

Investors tend to be risk-takers, but often or selectively, may seek to mitigate risk by reducing exposure. Reducing exposure can be done in two ways. One, by selling some or all of their shares. The implication here is known as opportunity cost in which the investor may miss out on potential financial gains by not being invested. Two, by mitigating risk through partial or equally offsetting investments in derivative instruments of either the underlying stocks they own or through the futures market in which the derivative is intended to represent the price and performance of the broad market.

What is a derivative?  A derivative instrument is an investment whose price is derived from the value of an underlying instrument. Both options and futures are examples of derivatives. Both derivative examples are often used for hedging purposes, although they can both be used to speculate efficiently on the value of the underlying financial instrument.

What are options? An option is a well-defined contract conveying rights for buyers and obligations for sellers. Such contracts allow investors to mitigate or offset risk during a specified time period. Options are often referred to as insurance on financial products, since their cost is referred to as a premium whose value is derived from the price of the underlying asset. Options typically have a strike price, which determines whether the contract at maturity has value or not. Call options enable holders to lock into a fixed price to buy the underlying asset, typically a stock, through expiration. Put options enable owners to lock into a fixed price to sell the underlying asset, typically a stock, through expiration.  

What are futures? A future is a well-defined contract typically providing leveraged exposure to a broad market index or commodity. Most futures contracts are exchange traded and bring together large or small investors to offer a large pool of liquidity, whereby the exchange assumes counterparty risk by guaranteeing all trades. The price of a futures contract is determined through constant buying and selling throughout the trading day, and often overnight. A futures contract typically represents a basket of an underlying index or commodity and most contracts are sold before the contract expires, so that very few investors ever hold them at maturity. Because they represent a basket of stocks, or an index, or a commodity, the price mirrors the price of the underlying asset upon which it is based offering investors highly liquid exposure to the market they want to be exposed to. Futures markets, therefore, act as a perfect way to either speculate or hedge exposure to an underlying asset.

What is a portfolio? A portfolio is the name given to all of the assets an investor owns. Someone who owns $10,000 worth of ABC Corp., $20,000 worth of Acme Company stock and $15,000 worth of XYZ Bonds has a total portfolio of $45,000. The concept of a portfolio is important when it comes to mitigating risk and trying to understand what the investor might do to hedge component pieces of the portfolio or adopt an overall portfolio hedging strategy.