An Indian business group manufactures tires and also owns and operates rubber plantations. So during the past year, when the war and pandemic disrupted the supply chains, inflation went off the roof. At that time, the commodity prices (crude, rubber, iron, etc.) shot up. This impacted the margins for the tire business, but rubber prices helped the plantations’ business grow. Similarly, as inflation is getting back in control, rubber prices are dwindling, but the tire business is doing really well.
This business right here is simply hedging its macroeconomic risks. But what is hedging, after all? While it might be an interesting topic to explore from a corporate perspective, today, we are more inclined to learn how hedging can benefit retail individuals like you and how we can mitigate different risks associated with it.
What Is Hedging?
Hedging in finance can be defined as offsetting the risk of an existing position by taking a position in an asset or derivative that reduces the risk of that existing position. Confusing much? Let us retry. Hedging is simply betting opposite to your existing bets to cover the losses in case of an adverse price movement.
Derivatives- the financial products that depend on an underlying asset’s price movement can be effectively used as a hedge as their relationship with the stock is clearly defined. These derivatives can take the shape of options, futures, swaps, and forward contracts that represent underlying cryptocurrency, stock, bond, etc.
How Hedging Functions
Analogy time. Have you purchased a life cover for yourself? Whatever the amount, I am sure your financial planning includes this key element of safeguarding your family in the unfortunate event of your death. In other words, you have hedged the risk of losing a roof over the head by purchasing insurance.
Hedging is very similar in nature. You buy insurance (of sorts) to ensure that losses don’t ruin your financial health.
Another key point to note here is that you pay premiums to ensure your life cover is always up and running. It is NOT free. Similarly, hedging also limits your profits to some extent while making sure that you are protected in case of a catastrophe.
Fund managers and retail individuals are exposed to risk with each trade. Therefore, they deploy multiple strategies to make sure that they minimize losses. This is done in a strategic fashion by taking controlled positions on the opposite side, depending on the analysis and probability.
Let us make it real for you using an example. Say the price of Bitcoin is $22,000 right now. You are already in profit and believe that Bitcoin is overvalued and the price may tank in the future. So you buy a contract that gives you the right to sell the Bitcoin at $21,000 at a future date (this is called a put option).
Now say the price of Bitcoin actually falls below $21,000. You can exercise your contract and limit your losses to $1000 per unit ( current price – price at which you agreed to sell). Of course, you would pay some premium to hold this contract. If the price remains the same or grows up further, you can let the contract expire while only paying the price of premiums.
Various Hedging Techniques
Hedging is usually done with the help of derivatives, as discussed above. However, inverse ETFs and diversification could also prove to be a great technique. Here are a few modes of hedging your portfolio risk.
1. Hedging with derivatives
Derivatives are contracts whose prices depend on an underlying asset. The effectiveness of the derivative hedge depends on something called hedge ratio or delta. It is the amount of price movement in the derivative per dollar movement of the underlying asset. The delta of a call option ranges between zero and one, while the delta of a put option ranges between negative one and zero. More on these individual derivatives shortly.
The cost of the hedge is usually dependent on the amount of downside risk of the underlying asset. For example, hedging against a volatile asset is likely to cost you more as compared to something relatively stable.
Example of hedging using a put option
Say Mr. X has purchased Ethereum at $1000. He wishes to hedge his risk of a downside, so he purchases a put option. This is a contract that allows him to sell his Ethereum for $900 (does not obligate, but allows) whenever he needs to in the next three months. Here the price of $900 is called the strike price.
Now some may think that this is very similar to a stop loss. But then, hitting a stop loss would mean that you have exited the market once the price is met. But this gives you the option to wait and watch. What if the price reaches $850 and later bounces back to $1200? Therefore, hedging using a put option makes a lot more sense.
Coming back to the example. Say this option costs $10 (consider this an insurance premium). Three months later, Vijay realizes that the price of Ethereum is $1050. At this point, he will let the option expire without exercising it and hence lose $10 as the premium amount.
Alternatively, if Ethereum has reached a level of $700, he can easily exercise the option and sell his holdings for a loss of $110 ($100 + $10 premium price). If he had not used the put option, he would have lost $300.
Example of hedging using covered calls
Calls are the opposite of puts. It gives people the right to buy a stock at a specified price during a given time period. In the same example above, say you want to hedge your Ethereum position against a downturn. So you can sell a covered call at a certain premium price.
In a covered call, the seller offers buyers a call option at a set price and an expiration date on a security the seller owns.
This means someone would look forward to buying this from you at a strike price as a hedge against their position. So just in case Ethereum falls below a certain level, you would have recouped your money through premiums.
Alternatively, if the price starts to rise, your gains are capped at the strike price.
2. Diversification as hedging
While derivatives are more defined and specific hedging methods, they often make sense when the capital involved is much higher. The good news is that derivatives are not the only method of hedging against risk.
Retail investors can take diversified bets within their portfolios to hedge risk. Although it is a very crude method of hedging, it does work in a lot of cases. For example, in the Indian context, the pharma industry is considered a hedge against market downturns. While it may not give you gargantuan returns, it surely does stand strong in the case of a downfall.
Closer to home, one could invest in different competing cryptocurrencies to hedge their risk. For example, if you are unsure which blockchain is going to make it big, a decent strategy would be to invest in Ethereum, the largest and oldest network in this space, followed by layer-2 solutions that can help in Ethereum scaling and eventually in Solana/Avalanche which are layer 1 counterparts of Ethereum. This way, you can see some upward momentum irrespective of the market sentiment. However, always DYOR (Do Your Own Research) before investing in any asset.
3. Spread hedging
This strategy is specific to traders dealing in index investing. Usually, the downturns are moderate, frequent, and unpredictable in the indices. Therefore, the priority of a trader changes from safeguarding against smaller downturns instead of a larger blip.
In this type of spread, the index investor buys a put that has a higher strike price. Next, they sell a put with a lower strike price but the same expiration date. Depending on how the index behaves, the investor thus has a degree of price protection equal to the difference between the two strike prices (minus the cost). While this is likely to be a moderate amount of protection, it is often sufficient to cover a brief downturn in the index.
Advantages of Hedging
While it is clear that hedging safeguards investors from sudden price movements, it does come at a cost. Therefore, it is worth discussing some of the real benefits of hedging.
1. Risk mitigation
The main benefit of hedging is to mitigate risks associated with your positions. You can choose the degree of exposure to the risks by hedging them properly. For large hedge funds, hedging is a lifeline that ensures they can stay in business at all times.
2. Limit losses
Even if the risk is limited, hedging ensures that your losses are under a check as you have indirectly insured against them. This is typically helpful while managing large sums of money.
3. Price clarity
One clear benefit of hedging for retail individuals is clarity in the pricing. This is typically used by farmers wherein they lock the future prices of the commodity to safeguard their interests in case of supply chain shocks. If the price of the commodity shoots up in the market, they can let the call expire or exercise it in case of a price crash.
Risks Associated With Hedging
Well, that’s the thing about risk management. It is all about context. There’s no playbook that can tell you about your next move in the stock market. Instead, there is a lot of practice and experience that goes behind making the right judgment. So, while hedging comes with a lot of positives, it requires a significant skill to decide if you need it or not. Because in some cases, it could also eat out your gains. Let us talk about this aspect of hedging.
1. Cost of hedging
We talked about it a few paragraphs ago. There is a significant cost associated with hedging. And this cost comes out of your profits. In case you hedged out of fear rather than a proper analysis, you are simply eating out of your margins. Imagine if a farmer buys a contract to sell his potatoes at Rs. 50/kg in 3 months of time and the spot price of potatoes is Rs. 60 during that period. He would simply lose on to the profits equivalent to the option price in that case.
2. Wrong analysis
This plays out when you are using diversification as a hedging technique. For example, you have significant positions in Sandbox ($SAND) (A Metaverse platform). You fear the loss of traction for this platform, so you also bet on the competing token Decentraland ($MANA). You are confident that you hedged your risk with Sandbox. However, with the pandemic being a thing of the past, people are no more interested in the virtual world. This would lead your hedging strategy to backfire.
What It Implies for Individual Investors
Time to address the elephant in the room. Should I, as a retail investor, be hedging my risks? Well, it depends on your investment style.
If you are into long-term, buy and hold kind of investing, hedging will not make any sense to you. This is because you are likely to ignore the short-term highs and lows while focusing on long-term profits. Therefore, paying for a hedge would actually harm your portfolio in such a case.
On the other hand, if your investment philosophy revolves around active investing or trading for short-term, quick gains, hedging might make sense for you. But then, you need to visualize the cost of hedging in terms of the percentage of your profits. This is why hedging for a bigger portfolio makes a lot more sense.
Another thing to keep in mind is that hedging is an imperfect science. It is a game of probabilities. You cannot hedge 100% of your risk. Even if you try to do that, the cost of hedging will come back to bite you.
Conclusion
Hedges are a necessary evil when it comes to managing large sums of money. Whales often deploy these strategies to safeguard their positions against losses. On the other hand, the HODL gang can completely avoid derivatives and best make some smart bets to create a well-diversified portfolio instead.
FAQs
1. What is hedging in stocks?
Hedging in stocks involves taking positions in derivatives or diversifying in a way that the risks of the downside of your existing positions are mitigated. For example, if you are investing in airline stocks, you can bet on fuel/energy companies so that the risk of thin margins due to price increases in oil is mitigated by the profits from the hedged stocks.
2. How much does it cost to hedge?
Hedging does not come at a fixed price. Its value depends on the underlying asset and the coverage period. For example, for a volatile underlying asset, the derivatives will be expensive and vice-versa. Similarly, hedging for a short period with relatively predictable swings might come at a lower price.
3. What are some examples of hedging?
A classic example of hedging involves a wheat farmer and the wheat futures market. The farmer plants his seeds in the spring and sells his harvest in the fall. In the intervening months, the farmer is subject to the price risk that wheat will be lower in the fall than it is now. While the farmer wants to make as much money as possible from his harvest, he does not want to speculate on the price of wheat. So, when he plants his wheat, he can also sell a six-month futures contract at the current price of $40 a bushel. This is known as a forward hedge.
