Investing in Hedged Equity

What Is A Hedge?

In simple terms, a hedge is an investment that is made with the intention of reducing the risk of a large and adverse price movement in an asset.

Hedging is similar to taking out an insurance policy. And like insurance, there is a cost to hedging. While it reduces potential risk, it also reduces potential gains, since the hedge is usually taken in the opposite direction as the asset being protected.

In the investment world, the most common way to hedge is through derivatives. These are securities that move in correspondence to one or more underlying assets. Derivatives can include options, swaps, futures and forward contracts.

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There are many kinds of options and futures contracts that investors are able to hedge against almost any investment, including stocks, fixed income, interest rates, currencies, commodities, and more.

The effectiveness of a derivative hedge is expressed in terms of delta or “hedge ratio.” Delta is the amount the price of a derivative moves per $1 movement in the price of the underlying asset.

The specific hedging strategy, as well as the pricing of hedging instruments, likely depends on the downside risk of the underlying security against which the investor would like to hedge. Generally, the greater the downside risk, the greater the cost of the hedge. Downside risk tends to increase with higher levels of volatility and over time.

For example, if you want to hedge your position in a highly-volatile tech stock, an option which expires after a longer time period and which is linked to this stock will be more expensive than say a short-term option on a consumer staple stock.

Note that funds designed for downside protection do not necessarily increase the likelihood of positive returns during market downturns.

Why Is Hedging Important?

Used wisely, hedging your portfolio can become part of your long-term investment strategy. Hedges can be applied and removed as needed, without disturbing your core strategy or long-term goals.

Most importantly, hedging can help provide short-term shelter from adverse market events. This provides you with an alternative to selling in a down market, being forced to take an investment loss and perhaps incurring redemption fees, transaction costs and tax consequences.

In essence, hedging is recognizing the dangers that come with every investment and choosing to be protected from any untoward event that can impact one’s finances.

As stated previously, hedging strategies have unique risks, costs and consequences of their own (management fees, taxable events, etc.). It is important that you fully understand the strategy you plan to use and read the prospectuses for any investments you intend to use as a hedge.

Examples of Hedging Strategies

There are several common hedging strategies investors use to help mitigate portfolio risk: short selling, buying put options, selling futures contracts (often on a stock index like the S&P 500), trading volatility, and using inverse ETFs.

Inverse ETFs rise in price when the market goes down. Retail investors often use these ETFs because they are less burdensome than the other hedging strategies. No margin, options or futures is needed to buy an inverse ETF.

Another common strategy involves the use of options. An option is an agreement that lets the investor buy or sell a stock at an agreed price (called the strike price) within a specific period of time.

Let’s say you own a stock. If you purchase a put option, and the stock falls in price, the put option will go up in price – offsetting at least some of the loss in the stock price.

How to Participate in Hedging Strategies

You’re already using hedges in your everyday life. The aforementioned insurance policies you buy are a hedge against future scenarios. While hedging will not prevent an incident from occurring, it can protect you if something bad happens.

So it makes sense to do the same in your financial life.

There are several ETFs and mutual funds that use hedging strategies that are designed to reduce risk. A simple search on Magnifi indicates numerous ways for investors to access these funds with low fees.

References:

“Hedge Definition: What It Is and How It Works in Investing”, April 24, 2023, investopedia.com, link
“Delta (Δ)”, January 19, 2023, corporatefinanceinstitute.com, link
“The Most Effective Hedging Strategies to Reduce Market Risk”, September 7, 2023, investopedia.com, link

Disclosures:

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The information and data are as of May 12, 2021 unless otherwise noted and subject to change. This blog is sponsored by Magnifi.

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Financial derivatives include but are not limited to futures, options, indexed securities, swaps, and forward contracts. Exposure to investments in derivatives can cause a portfolio to make gains or incur losses. Derivative transactions may be subject to the risk that a counterparty to the transaction will wholly or partially fail to perform their contractual obligations under the arrangement.

Options are not suitable for all investors. There are risks involved in any option strategy. Individuals should not enter into option transactions until they have read and understood the option disclosure document titled "Characteristics and Risks of Standardized Options," which outlines the purposes and risks of option transactions. This booklet is available from your Financial Advisor or at link. Supporting documentation of claims will be supplied upon request.

Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs, and international economic, political, and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.

Trading futures involves the risk of loss and is not suitable for all investors. Please consider carefully whether futures are appropriate to your financial situation. Only risk capital should be used when trading futures. Investors could lose more than their initial investment. You must review customer account agreement prior to establishing an account. Past results are not necessarily indicative of future results. The risk of loss in trading can be substantial, carefully consider the inherent risks of such an investment in light of your financial condition.

Indices are unmanaged and investors cannot invest directly in an index.

The Standard & Poor's 500 (S&P 500) Index is a free-float weighted index that tracks the 500 most widely held stocks on the NYSE or NASDAQ and is representative of the stock market in general. It is a market value weighted index with each stock's weight in the index proportionate to its market value.

Inverse mutual funds and ETFs, which are sometimes referred to as “short” funds, seek to provide the opposite of the performance of the index or benchmark they track. Inverse funds are often marketed as a way to profit from, or hedge exposure to, downward moving markets. Some inverse funds also use leverage, such that they seek to achieve a return that is a multiple of the opposite performance of the underlying index or benchmark (i.e., 200%, 300%). In addition to leverage, these funds may also use derivative instruments to accomplish their objectives. As such, inverse funds are volatile and provide the potential for significant losses.