A Beginners Guide to Stock Hedging
Hedging involves taking a position in the market with the aim of reducing risk. This may sound paradoxical to those unfamiliar with the concept. Shouldn’t the primary reason for entering the financial market be to make a profit?
In this article, we will explore in depth the idea of stock hedging and why many investors choose to do this. We will also examine a few of the methods that are used to hedge and much more!
What Is Hedging?
Hedging is a method of attempting to mitigate risk by opening an opposing position in the market. The idea behind this is that potential losses sustained in the main position, will be offset by gains in the opposing position.
The classic analogy is to think of hedging like an insurance policy against market risk. Much like a homeowner might take out insurance in order to protect their home from fire or burglary, an investor hedges their position in an attempt to control their exposure to risk if the market moves against them.
However, we should be careful about drawing too many parallels between these two concepts. Unlike insurance, there is no fully comprehensive guaranteed hedging strategy. The perfect hedge could be described as one which completely eliminates all risk in a position or a portfolio, but, it should go without saying, that when it comes to live trading and investing, there is no such thing as “risk free”.
In reality, hedging is adjusting the trade-off between risk and reward - seeking to reduce the overall risk of an investment whilst also lowering its potential reward. The most common way of doing this in the world of investment is by using financial derivatives, which were created with this purpose in mind.
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Stock Hedging Explained
Hedging can, and does, take place in all financial markets. However, in this article, we are focusing solely on explaining hedging in the stock market. Before we look in detail at how somebody would hedge in the equities market, let’s look at why they would want to do so in the first place.
As we have already discussed, hedging is a way of minimising the risk associated with investing and trading, by entering a position which opposes the first. When we talk about stock hedging, we are typically talking about a shareholder attempting to minimise the negative effect on their portfolio of a potential downturn in share price.
But hold on. If the shareholder is concerned about share price falling, why not just sell their shares?
Let’s say that an investor holds shares in Company A. The investor believes strongly in the long term growth of Company A and, therefore, wants to remain a shareholder for the long term. However, they have concerns about a possible short term fall in share price. The investor may choose to hedge their position in Company A in order to offset any potential losses incurred in the short term.
Why not sell the shares before the price falls and buy them back at the lower price? Would that not be simpler?
The problem with this approach is that it does not take into account any capital gains tax or trading costs which might have to be paid. Furthermore, in reality, we do not know what is going to happen with the share price. In our example, our investor is concerned about a short term fall in share price, but his concerns may not materialise. The price could remain the same or it could rise, adding to the potential losses already inflicted by capital gains tax.
Hedging With Financial Derivatives
The most common technique of stock hedging is undertaken using financial derivative products. A financial derivative is a security whose value depends on, or is derived from, an underlying asset, such as a company’s stock.
There are a wide variety of different derivative products available for traders, each come with their own characteristics, advantages and disadvantages. Here are a few of the most common:
An investor wishing to hedge their long position in the stock market can do so by taking a bearish position in their chosen, relevant financial derivative; and vice versa.
In the following sections, we will look at how this is possible with examples of stock hedging strategies using options and CFDs.
Hedging With Options
Options are a type of financial derivative which are popular when it comes to hedging strategies.
A stock option gives its holder the right, but not the obligation, to either buy or sell a particular stock at a fixed price, the strike price, on a set date, the expiry or maturity date. An option giving the holder the right to buy is referred to as a ‘call’, whereas an option giving the right to sell is called a ‘put’.
Now we are familiar with the terminology of options, let’s look at how an investor could hedge their equity position using options. For the purpose of our example, let’s imagine we have an investor who holds Apple shares and is concerned about a fall in the short term share price.
Depicted: Admiral Markets MetaTrader 5 - Apple Inc. Daily Chart. Date Range: 4 September 2018 - 20 January 2021. Date Captured: 20 January 2021. Past performance is not necessarily an indication of future performance.
In order to hedge their equity position, our investor could look at buying put options on Apple stock. Let’s say for simplicity that the investor holds 100 shares of Apple and one option contract is the equivalent of 100 shares, meaning that one put option is sufficient to hedge the investor’s position.
If the share price of Apple falls, the put option will increase in value, offsetting the loss in the investor’s equity position. The extent to which the option increases in value will depend largely on the scale of the fall in share price in relation to the strike price of the option.
If, on the other hand, the share price increases, the investor would obviously benefit from this increase through his ownership of the shares, but this gain would be offset somewhat by the price paid for the put option. Because options do not oblige their owner to take any action at the expiry date, their downside is limited to the price paid for the option, which is typically a small fraction of the value of the assets they are covering. Therefore, in this scenario, the option contract is likely to be left to expire as worthless.
The Disadvantage of Options
Options are a complex instrument to trade not least because of the way in which they are priced.
Although derived from an underlying asset, an option’s price is also influenced by the underlying asset’s volatility (the more volatile the underlying, the more expensive the option), and the time left until the expiry date (the further away this is, the more expensive the option will be). An investor must factor in these considerations if looking to hedge their stock portfolio using options.
Hedging With CFDs
Contracts For Difference (CFDs) represent a contract between two parties agreeing to exchange the difference in the price of an asset between when the position is opened and when it is closed.
Unlike options, there is no expiry date, meaning that the trader is free to close their position at any time. Moreover, the CFD price solely tracks that of the underlying asset without other influencing factors to consider.
CFDs allow traders to go both long and short on their desired market and also to benefit from the use of leverage, meaning that a trader need only put down a proportion of the position size, known as the margin, as an initial deposit.
As useful a tool as leverage is to a trader, it must always be used with caution. Whilst it has the potential to magnify a trader’s gains, it has equal potential to magnify their losses.
Stock hedging with CFDs requires an investor to take the opposite position on a CFD of the relevant stock, where one CFD is equivalent to one share. Continuing with our previous example, if our investor, who holds 100 shares in Apple wishes to hedge this entire position using CFDs, they could short sell 100 CFDs of Apple stock.
If Apple’s share price falls, the investor’s loss in share value would be offset by an equal gain in their short position on the stock CFDs. On the other hand, if Apple’s share price rose, the investor’s equity position would benefit at the expense of his CFD short position.
Unlike options, there is theoretically no limit to the downside with CFDs. However, traders can, and should always, trade using a stop loss, which will automatically close a losing position once it crosses a predetermined threshold.
The Disadvantage of CFD Hedging
Stock hedging with CFDs is certainly not without its negatives. An investor must factor in the fees associated with trading CFDs. This sometimes includes commission charged by the broker and always includes what is known as the swap.
The swap is interest which is charged on a trader’s position if it is held overnight. This may not make much of an impact when the position is held just for a few days, however, it can soon start to add up if an investor is looking to hedge a position over a longer timeframe.
You should now be more familiar with the concept of hedging in general, more specifically stock hedging, and a few of the methods employed by investors to achieve this.
In this article, we have looked at hedging in its simplest form, taking an opposing position in the same asset to mitigate risk. However, it is also common also for investors to hedge against a specific risk. For example, a shareholder of British Petroleum (BP) who is concerned about a dip in oil prices negatively affecting their investment may choose to hedge their position by short selling oil as opposed to short selling BP shares. Alternatively, they may wish to protect themselves against general market risk by short selling the FTSE100.
Hedging is an effective method of mitigating risk if done properly, however, it should be used as part of a wider risk management plan.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.