Hedging Stocks

Hedging Stocks With Options Meaning

You wouldn’t think twice about purchasing insurance for your car, house, heck, or 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 like having an insurance policy if your trades don’t work out.

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. Some people hedge with inverse product stocks or even the $VIX.

Protecting you and your assets during a market selloff or downturn is a lifesaver. 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 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.

What Is Hedging

Godfather of the Hedge Fund Industry

Born in 1900, Alfred Winslow Jones is credited with forming the first modern hedge fund. Jones implemented this plan by short-selling stocks and 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. He earned a cumulative return of roughly 5,000 percent in his first twenty years.

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.

Different investors still use fast-forward to today and hedging to protect themselves against downside risks using different methods.

Think of a trader with stocks in the airline industry worried about share prices falling due to COVID-19. Instead of selling all their shares and realizing a loss, they have another option: Hedging. The trader can buy a put option and profit on the way down.

Diversification

You’ve probably heard 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, a 20-stock portfolio is considered safer, 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!

Purchasing different financial assets ensures 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.

Pros of Hedging Stocks

Hedging has various pros; for one, the process will secure your capital if a black swan occurs.

For example, during the collapse of Lehman Brothers in 2008, the stockholders had no 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 businesses maintain things so they do not go from bad to worse.

The other advantage of hedging is that you get to keep your sanity. It will safeguard your peace of mind by safeguarding your capital.

You will sleep well at night, knowing you’re not taking on many risks. I know I like to sleep well at night, and worrying about money is the last thing I need right now.

COURSE
Day Trading Course Options Trading Course Futures Trading Course
DESCRIPTION Learn how to read penny stock charts, premarket preparation, target buy and sell zones, scan for stocks to trade, and get ready for live day trading action
Learn how to buy and sell options, assignment options, implement vertical spreads, and the most popular strategies, and prepare for live options trading How to read futures charts, margin requirements, learn the COT report, indicators, and the most popular trading strategies, and prepare for live futures trading
INCLUDED

Cons of Hedging Stocks

As much as hedging has various advantages, it also has drawbacks. Hedging your bets reduces your risk, but it usually lowers your potential gain, too.

Unfortunately, most strategies that hedge against the stock market falling reduce your gains in a bull market.

Likewise, another drawback is the transaction costs associated with buying another stock. Fees and trading costs will ultimately swallow up the capital you wish to safeguard.

My point is that you have to think about the trading costs and profit or loss estimates when you hedge.

Example

  1. Let’s say the banking sector will do well in the upcoming years. So you buy 500 shares of Scotiabank at $44.50 a share. Overall, this investment is going to cost you $22,250.
  2. On the other hand, you feel that this investment is a little risky right now, given we’re undergoing a pandemic. So, what should you do?
  3. Well, hedge your position by purchasing five put option contracts. Each option’s premium is $180, costing you $900 for the five contracts.
  4. The most important advantage to note is that they allow you to sell your shares for $40 at any time before Jan. 2021.
  5. Unfortunately, if Scotiabank falls to $30 per share by the end of 2020, your initial investment will be worth $15,000, for a loss of $7,250.
  6. 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.
  7. 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.

Final Thoughts: Hedging Stocks

In simple terms, hedging your investments is just like buying insurance. If the volatile market and stocks rapidly sing 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, a hedging plan will ensure you do not lose your investment.

But remember that 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?

When do I hedge? When I see an extreme amount of dark pool activity. Using lower-risk strategies like the options collar strategy can sometimes help you avoid having to hedge as much as someone with a higher-risk strategy.

Bullish Bears offers extensive courses, tools, and community support. Let us help you simplify and accelerate your trading journey.

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