You wouldn't think twice about purchasing insurance for your car, house, heck, even your life. Whether it be an unforeseen event such as a fire, flood or cancer diagnosis, the odds are high that one of us will cash in our policy. Hedging stocks is like insurance.
But did you know you can also purchase "it" for your investments? It's akin to having an insurance policy if your trades don't work out.
Hedging Stocks to Protect Yourself From Loss
- Do I have your attention yet? I should because if you're joining the game, you need to know how to protect yourself from losses in the stock market using hedging. Here's how. Avoiding risks in life and business is the route to failure. Instead, one needs to learn how to mitigate the risks. Hedging helps you to reduce risks.
It acts as a lifesaver to protect you and your assets during a market selloff or downturn. However, it also has its drawbacks after all; it is a bet that is against your interests.
To summarize, a hedge is when you buy an investment to reduce the risk of losses from another investment.
Typically, investors will buy the opposite of their position, such as buying a put option to hedge against losses in a long stock position.
Their rationale: A decrease in stock price will be (somewhat) offset by the gains from the put option.
1. Alfred Winslow Jones: The Godfather of the Hedge Fund Industry
Born in 1900, Alfred Winslow Jones is credited with forming the first modern hedge fund. Jones managed to implement this plan by short-selling stocks as well as ramping up leverage, leading to the introduction of the first hedge fund.
Even though the existing hedge funds in the current market apply different strategies to make money, Jones' idea for hedge funds was to get insurance against risks.
In 34 years of running his hedge fund, Jones had only three years that realized a loss. In his first twenty years, he earned a cumulative return of roughly 5,000 percent.
Put in perspective, this result would have turned $10,000 into $480,000 while crushing the market averages. Because of this, he is widely regarded as the father of the hedge fund industry and was one of the greatest money managers ever.
Fast-forward to today and hedging is still being used by different investors in protecting themselves against downside risks, using different methods.
Think of a trader with stocks in the airline industry who is worried about share price falling due to COVID-19. Instead of selling all their shares and realizing a loss, they have another option: Hedging. The trader can simply buy a put option and profit on the way down.
2. Diversification Is Considered Hedging
You've probably heard of the saying, "don't put all your eggs in one basket." In this case, your eggs are your securities, and you'd be a fool to put them all in one spot.
Similarly, that is why a 20 stock portfolio's regarded as a safer investment, unlike a portfolio of only Google or Amazon stock.
I don't think I'm alone in my thoughts that one of the best forms of hedging is diversification. And it's one of the oldest too!
Through the purchase of different financial assets, you ensure that your portfolio is not limited to a single industry or security. If an auto manufacturer undergoes tough times, you're OK because you have holdings in both the financial and tech sectors.
3. The Pros of Hedging Stocks
Hedging has various pros; for one, the process will secure your capital if there is a black swan occurrence.
For example, during the collapse of Lehman Brothers in the year of 2008, the stockholders had no other choice but to have useless holdings that had reduced to a mere fraction of the original price.
Hedging will come in handy and protect you from such outcomes. It can help a business to maintain things so that it does not go from bad to worse.
The other advantage of hedging is that you get to keep your sanity. It is it will safeguard your peace of mind by safeguarding your capital.
You will sleep well at night, knowing you're not taking on a lot of risks. Personally, I know I like to sleep well at night and worrying about money is the last thing I need right now.
4. The Cons of Hedging Stocks
In as much as hedging has various advantages, it has drawbacks as well. Hedging your bets reduces your risk, but it usually lowers your potential gain, too.
Unfortunately, most strategies that hedge against the stock market falling reduces your gains in a bull market.
Likewise, another drawback is the transaction costs associated with buying another stock. In the end, the capital you wish to safeguard will be swallowed up by fees as well as trading costs.
My point is that you have to think about the trading costs and profit or loss estimates when you hedge.
What Is Hedging in Stock Market With Example?
- Let's say you think the banking sector is going to do well in the upcoming years. So you go out and buy 500 shares of Scotiabank at $44.50 a share. Overall, this investment is going to cost you $22,250.
- On the other hand, you feel that this investment is a little risky right now, given we're amid a pandemic. So, what should you do?
- Well, an hedge your position by purchasing five put option contracts. Seeing that each options premium is $180, it costs you $900 for the five contracts.
- The most important advantage to note is that they allow you to sell your shares for $40 at any time before Jan. 2021.
- Unfortunately, if Scotiabank fell to $30 per share by the end of 2020, your initial investment would be worth $15,000, for a loss of $7,250.
- However, in this scenario, your put options have an intrinsic value of $5,000. And once you do the math (subtract the $900 you paid for the contracts), you'll see you made a profit of $4,100.
- Overall, your hedge resulted in a loss of $3,150. Even though it is still significant, it's much better than the $7,250 you would have lost if you didn't hedge.
The Bottom Line
In simple terms, hedging your investments is just like buying insurance. If the market if volatile and stocks are rapidly singing up or down, hedging should be your new best friend.
Hedging is an effective approach, especially during uncertain times. There is always a chance that a trade can turn against you. However, having a hedging plan in place will ensure you do not lose your investment.
But keep in mind, not all of your investments need to be hedged, especially if you're confident about your stock picks in the long run. Are you curious to learn more?
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