What is Hedging?
Hedging is a financial strategy employed by individuals (and organizations) to mitigate or reduce the risks associated with fluctuation in asset prices, interest rates, currency values, commodity prices and maybe even fantasy football. This strategy involves taking offsetting positions (i.e., hedging your bets) in related instruments or markets to protect against adverse price movements.
Why Should I Hedge?
Depending on your appetite for risk, hedging can be used to protect yourself from an unfavourable outcomes when you’re investing. Here is a super simplified example:
Imagine you have $50,000 in tech stocks, but you’re worried about a market crash that will impact tech stocks. To protect your investment, you spend $2,500 on put options on an ETF that tracks the tech sector. If the tech sector does dip, these options let you sell your position in the ETF at a higher price, thereby limiting your losses from the market drawdown. If, however, the market and the tech sector continues to climb, you still have your tech position which has benefited from the market’s growth, and your put options will have likely expired.
Types of Hedging
- Futures & Options Contracts: these are some of, if not the most, common hedging instruments for investors. Option contracts provide the right but not the obligation to buy or sell an asset at a predetermined price, giving investors flexibility in managing risk.
- Currency Hedging: companies engaged in international trade often use currency hedging to protect against adverse exchange rate movements (for more on this topic why the USD is so important, click here).
- Commodity Hedging: producers and consumers of commodities frequently use hedging to guard against price volatility in a specific industry. For example, oil companies can use futures contracts to secure the price that they will pay for crude oil in the future.
- Interest Rate Hedging: this strategy is employed to manage interest rate risk. For example, a company with a variable-rate debt (i.e., a line of credit, mortgage, etc.) might enter into an interest rate credit swap to convert it into a fixed-rate obligation.
What does Hedging do?
Whether you’re a company or an individual investor, this strategy has several advantages:
- Risk Reduction: by locking in prices and/or rates, individuals and businesses can protect themselves from adverse market movements in an effort to limit down-side exposure.
- Stabilize Cash Flow: Hedging can help ensure predictable cash flows, which allows a business to have more certainty in its budgeting and financial modeling.
So, to Hedge or not to Hedge?
Of course, hedging is a more complicated strategy that many investors need not worry about. For the vast majority of retail investors, especially those navigating their investments on their own, this strategy would likely add complexity and unnecessary confusion. Over time, some of the most simple (and boring!) strategies are tried and proven to create long-term wealth. An example of this is investing in low-cost index funds, such as VFV (for a full breakdown on VFV versus VOO, click here!).
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