Investment Hedging Explained
Investment hedging is an important element all investors should familiarize themselves with.
There is no doubt about the fact that your investment portfolio’s protection is just as – or even more important than its appreciation.
And just like your neighbor’s bizarre obsession with his garden, hedging is something that is often more talked about than being fundamentally explained, which seems as if it is the only exclusive cog in the big financial realm.
Well, even if you’ve just started investing, you can still understand what the term means and implies – the techniques involved in making it work, and how several companies use it to protect their investments.
Gold as an Inflation Hedge
Gold can be used as an effective hedge against inflation. For example, if the dollar were to drop in value due to inflation, gold has a tendency to become more expensive or rise in value.
If an investor owns gold they would be protected (hedged) against the falling dollar. In this article, Bob Pisani, a respected gold analyst, explains why gold is an effective hedge not only against inflation but unexpected events such as the coronavirus.
This is because inflation rises and decreases the value of the dollar. This, in turn, will result in an increase in the price of gold. This results in the investor being compensated for the inflation by receiving more dollars for each ounce of gold owned.
Other Forms of Investment Hedging?
The simplest and most relevant way you can understand hedging is to consider it as insurance.
When investors decided to implement hedging techniques, they are consistently putting up a wall for their investment portfolio against a potentially risky or a negative event.
Although this tactic does not stop the negative event from taking form and causing a bit of a panic, it does, however, reduce the impact of the event on your portfolio that is if you are adequately hedged.
So, there is no doubt about the fact that hedging is a common occurrence in the financial realm, especially in investors.
To help clarify things a bit more profoundly, think of your house insurance, you’ve bought it to protect or hedge yourself from damages in case of a fire, a natural disaster, drainage, break-in, etc.
Individual investors along with several portfolio managers and companies use a plethora of effective and efficient hedging strategies and streamlined techniques to minimize their portfolio’s exposure to numerous market risks.
However, in the realm of finance, hedging can become increasingly complex elements, far intricate than simply paying a yearly premium to an insurance company.
Hedging against the risks in the financial markets means tactfully, strategically, and analytically utilizing different market instruments to counteract any risk of unsuspected and un forecasted price movement(s).
In other words, what individual investors mundanely indulge in is making an investment to hedge or protect their portfolio against another investment.
Technically speaking if you were to hedge your portfolio, you would have to invest in two different types of stocks or securities, and both of them should have negative correlations.
You have to understand that nothing is free in this world, and neither do things like these come cheaply – meaning, you will still have to make payments for this type of insurance – how you make these payments is up to you.
Although there is no question about the fact all investors would like to fantasize about a more utopic financial environment where all of them could enjoy limitless potential when it comes to profits – and not only that but profits that are absolutely risk-free.
We have to indeed snap out of our dreams and realize that hedging cannot really enable us to escape the clutches of a risk-return tradeoff.
When you talk about hedging against risk, you also have to understand that you may have to sit well with reduced profits.
So, in essence, hedging is not a way you can make more profits, it is an accumulation of strategies that will only help protect your investments from a potential loss.
If you are hedging against a profitably, but risky investment, you have put a lock on the money you could have made if there wasn’t a hedge against it.
How Can I Hedge My Investments?
Hedging strategies usually consist of the utilization of complex financial instruments, which are known as derivatives.
And two of the most common derivatives in the investment world are known as options and futures.
Although we won’t be going into the details of these derivatives, it is important that for now, just remember that with the help of these two derivatives you can form a trading strategy and tactics where a potential loss resulting in one investment is offset by a profit in a derivative.
Let’s just at a few examples of how derivatives work. Let’s assume that you own shares of Jackson’s Tequila Company (ticker: JTC).
Although there is no doubt you have strong expectations of this company in the long run, you are still a bit uneasy about the short-term losses prevailing in the tequila industry.
So, to hedge yourself from these losses in JTC, you can purchase a put option, which is a derivative of JTC. This option enables you to exclusively exercise your rights to sell JTC shares at a particular price, which is known as (strike price).
This tactic is popularly known as a ‘married-put’. So, what happens is, when you begin to experience a drop in JTC share price, below the strike price, these losses incurred will be countered by gains in your put-option.
Another classic example to explain hedging consists of a business organization that depends on a specific commodity.
For example, let’s assume that Jackson’s Tequila Company is a bit on edge about the volatility in the price of a crucial element that helps make quality tequila, known as agave.
The business could take a damaging blow should the price of the plant agave increases exponentially – which would no doubt result in reduced profits.
So, in order to protect or hedge against the volatility in agave prices, JTC can effectively form a futures contract (or sometimes known as forward contract, which is less regulated), enabling the business to purchase agave at a specific price set sometime ahead in the future.
This enables JTC to form its budget effectively without having to worry about the price fluctuations of agave.