Traders use hedging strategies to reduce risk. Hedging involves taking positions that offset each other: If one position loses value, the other gains value. Hedges can be applied and removed quickly, providing dynamic protection during times when the primary position is at heightened risk. Traders use hedging because it provides low-cost insurance against large losses. The downside is that a hedged position can cut into profits when the primary position appreciates.
Hedging With Offsetting Stock Positions
When you buy stock, you have a “long” position. You can partially or entirely offset a long position by going “short” -- borrowing shares of the same stock and then selling them on the open market for cash. You will eventually have to return the borrowed shares. If the stock price goes down, your short position gains value, because you can buy the replacement stock for less than the cash you received when you originally sold it. Alternatively, you can simply use your long position to return the borrowed shares. In either case, you are protected from downside risk below the price at which you originally sold the short shares. This also works in reverse: You can hedge a short position by going long.
Hedging With Options
Options are contracts that provide the right, but not obligation, to buy a given asset, in this case a stock, for a specified price on or before an expiration date. A buy is done via a call, a sell via a put. A put buyer or call seller is worried that a long stock position will lose value. A call buyer or put seller is protecting against a loss on a short stock position. By buying and selling option contracts, a trader can craft a protective strategy perfectly suited to her needs. Each option contract hedges 100 shares of the underlying stock.
Hedging With Single-Stock Futures
Unlike options, futures are contracts that oblige traders to deliver or accept delivery of the underlying shares of stock. For example, if you are long 100,000 shares of XYZ stock, you can sell single-stock futures contracts for 100,000 shares of XYZ at a price agreed upon in advance. The sold contracts gain value if the stock price falls and vice versa. Hedging with futures is efficient because of margin -- the cash deposit required to enter into a contract. Since margin is typically only 2 to 10 percent of the contract’s value, traders can hedge large positions without laying out a lot of cash.
Hedging With Convertible Bonds
When hedging with convertible bonds, a short stock position is offset by a long position in convertible bonds, which can be converted into the stock you are hedging if the stock price rises above the bond’s conversion price -- the effective price at which a bond is converted to the underlying stock. If the stock price is just below the conversion price, the bonds will protect your short stock position should the stock price rise; the total value of the convertible bond position should appreciate faster than the value of the underlying stock as the stock price moves above the conversion price. Conversely, if stock prices decline, your short position should appreciate faster than your bond position loss, because the bond’s interest cushions its downward move.
Video of the Day
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