Hedging has most recently been in the headlines in the context of battling inflation, but it’s a fairly common risk management strategy for many investors. While hedge funds combine complicated hedging maneuvers to outsize their returns, individual investors can use simpler hedges and focus on offsetting loss. The goal of hedging, for a hedge fund and an individual investor, is the same — to reduce market risk. Popular hedging strategies that use portfolio optimization theory, derivatives and the volatility index indicator (VIT) rely on different tools but work toward this same intent.
Hedging is contingent on offsetting loss by taking an opposite position on an investment. A classic example that’s often used to demonstrate taking opposite positions on a related asset is a futures hedge, which is a form of a derivative strategy. Suppose a wheat farmer plants her seeds in the spring and sells her harvest in the fall. In those few months, the price of wheat can change. To protect against the uncertainty, the farmer might enter into a futures contract that allows her to sell her crop at a specific price at a set date in the future. The farmer is effectively lowering her market risk, or the risk of loss due to market variables, which in this case is price.
In a sense, if investing is revving up the engine, hedging is like remembering to put on a helmet. The premium is the upfront fee that’s required for the protection, which in the example above was the purchase price of the futures contract. Needless to say, there’s a chance that the hedge won’t be needed, in which case the investor incurs loss from the premium.
The most common types of hedges involve derivatives, or financial contracts that derive their value from specific assets or benchmarks. Investors can use futures and options, both derivatives, to hedge against individual stocks.
When buying put options to protect against the risk of a downside move for example, the aim is to gain value if the price of the underlying security (the stock) goes down. In this case, even if the investor is incurring loss from the stock going down, she’s also gaining on her puts. Meanwhile, futures are also bought and sold with market moves in mind, but there’s an obligation to act even when it’s not favorable. So an investor might lose their investment in the option when the price moves against them, but when the price moves in their favor they can let the option expire. Futures don’t offer this option, and instead bind the buyer/seller to buy or sell the underlying security, at a fixed price and a predetermined time.
The cost of derivatives depends on the downside risk of the security, or the likelihood that the value of a stock will drop if market conditions change. So if it’s an asset that’s more prone to volatility, and therefore can yield the investor more profit with a hedge, the premium will be higher and the investor’s margins will be lower. Certain types of derivatives like vertical put spreads can reduce the premium spent by investors with diversified holdings, but don’t apply to single stock holders.
Despite a fairly straightforward approach, derivatives have many drawbacks and a historic streak of low returns. While options are subject to time decay and have relatively expensive premiums, futures require accurate conjectures about upcoming market trends.
Profile optimization theory is at the center of the second hedging strategy. In this case, an investor curates a portfolio with the objective to maximize return, and minimize financial risk. Modern portfolio theory (MPT), which advocates for a diverse group of assets to reduce volatility, is the most popular type of portfolio optimization that investors use to hedge.
Pioneered by the American economist Harry Markowitz in 1952, MPT quantifies the benefits of diversification, or the “don’t put all your eggs in one basket” approach. Going off of the same metaphor, MPT also says to choose baskets not at random but in working combinations.
A perfectly diversified portfolio according to MPT would have every portfolio fall on the efficient frontier, or the set of investment portfolios expected to give the highest returns at a set level of risk. The efficient frontier can be represented on a graph, where percent return is plotted against risk, defined by the model as the standard deviation from the average, or the mean of expected return. In other words, it’s the chance of losing money.
As with any theory, MPT has shortcomings in the real world. For starters, it requires investors to reevaluate risk. Usually investors are risk averse, and MPT hinges on taking on risk on some stocks to reduce the overall risk of the portfolio. This somewhat counterintuitive approach can be a tough sell to an investor not familiar with the benefits of sophisticated portfolio management. Furthermore, MPT assumes stock performance isn’t interrelated. But historians have shown that in times of market stress, seemingly independent investments can act as though they’re related.
Still, MPT and its core ruling principle, diversification, remains one of the most widespread investor strategies to offset loss in more volatile markets.
The third hedging strategy most often used by investors utilizes the volatility index indicator (VIX). Referred to as the fear gauge, the VIX rises during periods of increased volatility. Generally, a level below 20 indicates low volatility, while a level of 30 or over means high volatility. There are exchange-traded funds or ETFs that track the VIX and investors can use these ETF shares or options to go long on the VIX as a volatility-specific hedge. Most ETFs must be held for a very long-term time to produce profits.
It’s no wonder that inflation and hedging go hand in hand; declining purchasing power is the perfect time to hedge against loss. There are numerous ways investors can do this and no shortage of information on how. Check out more content on hedging here.
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