Hedge Strategies for the Individual Investor

For investors, hedging is the practice of purchasing securities in a combination that reduces portfolio risk. Under most hedging strategies, the investor will take two positions with negative correlations. The two most common financial instruments used for hedging are options and futures. While there is no way to completely eliminate market risk, proper execution of hedging strategies can reduce that risk.

While the benefits of hedging include financial risk management and the limiting of financial losses, a reduction in risk always mean a reduction in potential profits. Hedging is a technique that does not increase profits, but limits potential losses. So, if the investment you are hedging against makes a profit, your hedge against loss will reduce that profit. If the investment loses money, the hedge minimizes that loss.

The two most common forms of hedging are options and futures.

Options: A Put Option gives the buyer the option to sell a particular stock at a specified “strike” price. The buyer of the option pays a “premium” for this. If the price of the underlying stock falls below the strike price before the expiration of the option, the owner of the put option can exercise the contract. If the stock price rises, the investor would not exercise the option (choosing instead to let it expire). The premium paid is most the holder of a put option can lose.

A Call Option gives the buyer an option to buy at a specific price until a specified point in time. Call options can be used to hedge against short positions.

Futures: Futures are financial contracts obligating the buyer to purchase an asset (such as a stock) or a seller to sell an asset. The main difference between options and futures is that the holder of a futures contract is obligated to fulfill the transaction outlined in the contract while the holder of the option has the right to buy or sell the underlying security, but not the obligation.

As an example, stock market index futures (futures contracts that replicate the performance of a selected stock market index) can be used to hedge against an existing stock position.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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