Hedging Stocks Explained
Hedging involves taking a position in the market with the purpose of reducing risk in another position. This may sound strange to those unfamiliar with the concept, shouldn’t the primary reason for entering the market be to make a profit..?
In this article, we will explore stock hedging in detail, look at why investors may choose to hedge equities and demonstrate how to hedge stocks using Contracts for Difference (CFDs).
Table of Contents
What Is Hedging in the Stock Market?
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 might choose to hedge their portfolio in an attempt to mitigate risk if the market moves against them.
The word mitigate is important here. Hedging does not totally eliminate the risk of investing, which is an inherently risky activity. Instead, hedging adjusts the trade-off between risk and reward by attempting to reduce the overall risk of an investment whilst also lowering its potential reward.
Hedging takes place in all financial markets; however, in this article, we will focus solely on hedging in the stock market.
Hedging Stocks Explained
When we talk about hedging stocks, we are typically talking about a shareholder attempting to minimise the negative effect on their portfolio of a potential downturn in share price. But why might an investor want to hedge shares?
Let’s say that an investor holds shares in Company A. The investor wants to be a shareholder in Company A for the long-haul, as they are convinced the company will be a long-term success, but they have concerns about a possible drop in share price in the short-term.
In this scenario, the investor may choose to hedge their stock position in order to offset potential losses in the short-term. But if the investor is concerned about share price falling, why not just sell the shares and then buy them back for a lower price?
The problem with this approach is that it does not take into account any capital gains tax which might have to be paid on the investor’s potential profits, or other costs such as commissions.
In reality, the investor does not actually know what is going to happen with the stock. The feared fall in price might never materialise. Share price could remain the same or, worse, increase, exacerbating the losses already potentially incurred by taxes and fees.
How to Hedge Stocks
The most common method of hedging equity risk is by using financial derivative products - such as options, futures and CFDs.
Such products derive their value from an underlying asset and can be used to speculate on both rising and falling prices, which makes them ideal vehicles for hedging a stock price.
In order to hedge a stock position, investors can use a financial derivative product to take a short position in the same stock. Consequently, potential losses in the main position would be offset by gains in the short position.
Stock Portfolio Hedging with CFDs
Let’s take a look at a hedging example in the stock market using CFDs. CFDs represent a contract between two parties in which they agree to exchange the difference in an asset’s price between the opening and closing of the contract.
As with other derivative products, CFDs can be used to go both long and short on an asset’s price, meaning that they can be used for stock hedging purposes. CFDs also benefit from the use of leverage, meaning that traders and investors only need to put down a proportion of the position size as a deposit.
Whilst leverage can be a useful tool, it is important to remember that it must be used with caution as it has the potential to magnify potential losses as well as potential gains.
In order to hedge shares, an investor can initiate an opposing position using a stock CFD of the relevant stock, where one CFD is equivalent to one share.
Let’s say that an investor holds 100 shares in Apple and wants to hedge their entire position. In order to hedge this position, the investor 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 a gain in their short position on the Apple CFDs. On the other hand, if Apple’s share price rose, the investor’s equity position would benefit at the expense of their short CFD position.
CFD positions can be closed at a time of the investor’s choosing. Consequently, if the investor is correct about a dip in share price, they are able to close their CFD position when they are satisfied that the downward movement has come to an end.
Disadvantages of Stock Hedging Using CFDs
Hedging stocks with CFDs is not without its negatives. An investor must factor in the fees associated with trading CFDs when using them for the purposes of hedging equity risk. 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 for just a few days. However, it can soon start to add up if an investor is looking to hedge a stock over a longer timeframe.
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FAQ
How do I hedge my stock position?
Investors can use financial derivatives - such as options, futures and CFDs - to hedge a stock position by offsetting potential losses in a main position with potential gains in the derivative position.
How to hedge stock with options?
To protect themselves from a falling share price, investors might choose to hedge using options. In order do to so, the investor could buy a put option on the stock in question. Put options give their holder the right, but not the obligation, to sell an underlying asset at a specific price, known as the strike price. If share price falls below the strike price, losses in the main position will be offset by gains in the put option.
How to hedge the S&P 500?
As well as hedging individual stock positions, investors can also hedge a stock index such as the S&P 500 using financial derivatives. For example, an investor could hedge the S&P 500 by using futures or CFDs to take a short position against the S&P 500 or against a specific S&P 500 ETF.
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