You have probably heard the term "hedge your bets," which, under one definition, means to make smaller bets on different outcomes in case your large bet does not work out. Hedging in the stock market works the same way. You set up strategies or buy securities in case your stock market investments go down in value instead of up.
How Hedging Works
Stock market strategies can be divided into speculating and hedging strategies. If you buy a stock on the belief the stock will go up in value, you are speculating on that stock. You could also speculate the stock will go down by selling shares short. If you own stocks you expect to go up in value, and you buy a security or set up a strategy that will offset or minimize any losses if your stocks go down, you are hedging your stock market investments. Hedging protects against potential losses if a speculation does not work. In this use of the term, speculation can be a long-term stock market investment plan as well as short-term trading.
Types of Market Hedging
There are different ways to hedge stock market investments. A simple hedge is to set stop-loss orders against your stock investments. A stop-loss order directs your broker to sell your shares if the price declines to a preset level. The stop-loss hedges against the risk of a large decline in your stocks, instead producing a smaller loss if the hedge is triggered. Other ways to hedge in the stock market are to buy put options on individual stocks or market indexes, sell short stock index futures or buy shares of inverse exchange traded funds, or ETFs.
Costs of Stock Market Hedging
All hedging strategies have an associated cost. The costs may be the actual cost to purchase the security or lost profits if your hedge reduces the gains if stocks go up instead of down. For example, it costs very little in commissions to sell short stock index futures. However, if the stock market goes up, a futures contract will decline in value by about the same amount of money you gained in the stock market on the portion of your portfolio hedged by the futures. An inverse ETF will produce similar results to using futures -- a close to zero gain or loss result. With options, you can only lose the money you paid for the options, so a big market gain can cover the cost of put options used to hedge. However, options are only good for a limited amount of time and if you predict incorrectly when the market will fall, your hedging with options may be ineffective.
Should You Hedge?
The decision as to whether to employ hedges on your stock market portfolio depends on several factors. Consider the size of your portfolio, whether your outlook is long- or short-term and your familiarity with the derivative securities products used to hedge the market. Most individual stock market investors do not attempt to hedge against losses and accept the shorter-term up and down swings in the market. If you want to try to hedge against a down market, consider hedging a portion of your portfolio and judging the results and costs for yourself.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.