WHAT IS HEDGING
AND HOW DOES IT WORK

Buying or selling one asset can offset risk associated with other positions, or your entire portfolio. Done correctly, hedging can act as an insurance policy and smooth out returns. This guide will explore what hedging is and how you can get started.

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One of the core practices of investing in stocks is called “hedging”. You’re probably already familiar with how it works from other parts of your life — the phrase: “Don’t put all your eggs in one basket” rings true here.

So, what is hedging exactly, and how can this popular risk-management strategy help offset losses? In this guide, we’ll walk you through all of the intricacies of hedging and how it works, and then provide some helpful hedging strategies.

What is hedging?

Hedging is a risk-management strategy that aims to minimise potential losses and reduce the overall volatility of investment returns. Think of it like taking out insurance for your brand-new car or getting home and contents insurance against the risk of fire or storm damage.

When it comes to managing the risks of trading, one of the most common strategies is hedging. While it can’t eliminate risk entirely, hedging can help you insulate your portfolio against a variety of risk factors while potentially helping you to minimise losses, especially when the market is volatile.

There are several in-depth ways you can hedge — ranging from derivatives, such as options and futures, to inverse ETFs, investing in commodities and cash.

How does hedging work?

Hedging involves putting on additional trades designed to reduce risk on existing positions, limit losses, but also lower potential overall returns. Think of it in terms of multiple trades. You’ve already made an initial investment in a stock, for example, and you want to hedge it — so you make another trade that will deliver a profit if your first trade ends up going down.

You are essentially betting against yourself; however, you’re also gaining greater control over the potential outcomes. You do, however, need to ensure that you are removing enough risk while also not limiting your potential gains.

What are the advantages and disadvantages of hedging?

Hedging is not for everyone, so before you make the decision to include hedging as part of your overall investment strategy, consider some of the pros and cons:

What are some common hedging strategies?

While the concept is simple to understand, actually using hedging as an investment strategy is more complex. There are countless ways you can hedge, and not all of them will be accessible depending on your market knowledge.

Direct hedging

This strategy involves taking opposite positions on an asset. So, if you already hold a long position on an asset, direct hedging would be taking a short position on it as well.

Pairs hedging

Pairs hedging, sometimes referred to as pairs trading involves simultaneously taking a long position and short position in two similar assets. The strategy incorporates a degree of market neutrality, and net returns are determined by the relative performance of the two positions. The challenge is finding two opportunities where the stocks are trading at unusual prices, which takes time and research.

Trading safe havens

Safe havens are asset classes that generally retain their value — or even rise — during times of uncertainty. Gold, for example, is a common choice for investors wanting to protect themselves against a market crash.

The differences between a short hedge and a long hedge

There are two common hedging techniques used by traders and investors: short hedges and long hedges. But what are they, and how are they used?

What is a short hedge?

A short hedge is a technique employed by investors and traders to protect themselves from the risk of an asset they hold declining in value in the future.

It involves taking a short position and is typically used when an investor already expects to sell the asset rather than keep it as part of their portfolio in the long term. An individual may sell the underlying asset or take a short position in a futures contract.

If you were to buy 10 shares in a company for $10 each but believed that the stock would decline in value in the future, you could enter a futures contract, allowing you to sell the stocks at an agreed price at a later date. If the value of each share dropped to $8 in the future, but your futures contract had a predetermined value of $10 per share, you would avoid making a loss.

What is a long hedge?

A long hedge is a strategy employed by investors and traders to mitigate against the risk of an asset rising in value in the future. This strategy sees individuals take a long position. Some may choose to enter a long position in a futures contract, or they may decide to purchase the underlying asset that is expected to rise in value in time.

If you were considering purchasing 10 shares of a company for $10 each in the future but thought the value of the stock would increase over time, you could enter a long position with a futures contract. If your futures contract had a predetermined value of $10 per share, for example, even if the value of each share increased to $15, you would still only pay $10 per share.

How can you start hedging in trading?

There are many ways to start hedging in trading, however, if you’re just starting out, it may be wise to follow what many traders and investors choose to do, such as hedging derivative products.

Some examples of instruments used for hedging include:

Options	An instrument that gives an investor the right to buy or sell an asset at a predetermined price and time without obligation. If the asset does not perform as expected, the holder may let the position expire.
ETFs	A type of managed fund that allows investors to diversify their portfolio across various sectors and asset types without purchasing the underlying assets. They can be bought and sold like stocks, with various ETFs available.
Futures	Agreements made between two parties to buy or sell an asset at a predetermined price and time. They are generally used to lock in the price of assets affected by market fluctuations.
CFDs	Agreements made between brokers and traders to exchange the difference in asset price between opening and closing a position. This opens traders to take positions in both directions, neutralising market exposure.

Final thoughts

In all things, you should balance any benefits of hedging against the potential for losses. Understanding that hedging is a strategy that may not always pay dividends is critical. Many traders use hedging as a risk-management solution, but it is not the only strategy available. 

Visit the eToro Academy to learn more about investing.

Quiz

FAQs

Is hedging the same as portfolio diversification?

Although hedging and portfolio diversification are both strategies used to help reduce risk when investing, the two are not the same. Hedging is a strategy that involves taking an offsetting position to limit losses in a specific asset. Portfolio diversification looks to reduce risk across a broader portfolio through investment in varied assets.

What are hedging instruments?

Hedging instruments are any financial products that may assist investors in reducing their risk. While many different instruments can be used to hedge, some of the most common include CFDs, options and futures contracts.

Is hedging illegal?

Hedging is legal in most countries. It is, however, illegal to hedge while forex trading in the United States.

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