Hedging for Beginners: A Guide

10/20/2015 8:00 am EST

Focus: OPTIONS

Investors and traders hedge if they're concerned about their portfolios and want to protect them, so Zina Kumok, at Investopedia.com, highlights the two ways to hedge—through diversification and through options—as well as when and how to hedge and when not to hedge.

If you were around during the Great Recession, you’d have heard about derivatives and hedge funds. Despite their negative association with the Wall Street Crash of 1929, there’s nothing inherently bad about those assets.

Hedging, in its most basic definition, is the act of protecting yourself in case an unforeseen event happens. Insurance is one type of hedge, such as buying a policy for your car to protect yourself in case of an accident. In the context of investing, hedging is one way you can diversify your portfolio. By hedging, you can ensure that you’ll have some protection in case the market tanks your assets.

When and How to Hedge
People hedge if they’re concerned about their portfolio and want to protect it. If you’re worried about the price of gas falling, your hedge would ensure that if it did fall, the impact on your portfolio would be lessened. In the event that the price of gas rose, your profits would also be minimized if you had a hedge against rising prices. Using a hedge is like putting a filter on every photo you take, it will make your imperfections smaller but might take away the natural beauty of the original photo. Still, most people would rather take a slightly blurry photo than no photo at all.

“Hedging your investment risk can be a powerful tool, but one that’s too often neglected by investors,” said Joseph Hogue of PeerFinance 101. “Far from the misconception that hedging is a technical process only for big-time money managers, everyone should look to reduce their risk through a couple of strategies.”

There are various forms of hedging. Simply by diversifying your portfolio among a wide variety of asset classes in a range of industries will make sure that you’re safe from the ups and downs of the market. Diversification is one of the simplest ways to hedge your portfolio and one that your financial advisor can help you with.

Another way to hedge is by buying options, which can guarantee that your shares will be sold at the price you desire or let you buy shares for your ideal price.

“Options are contracts based on the price of a stock that involve the right to buy or sell the stock at a date in the future,” Hogue said. "Buying call options allow you to lock in a price for shares of a stock while buying put options allow you to sell the shares for a specific price.”

When Not to Hedge
Although it’s usually a practical and simple step to safeguard your financial well-being, hedging isn’t always needed.

“Hedging is not necessarily something investors must do,” Hogue said. “Think of it as another tool in your toolbox. You don't need two kinds of hammers, but having two different kinds, say a traditional and a drywall hammer, will help you more precisely. Hedging should not be used to time the market but to reduce risk for a specific purpose or goal. If you need the money or a specific return within a specified period then hedging can help you reduce the risk that your investment will fall below the amount you need.”

The Bottom Line
People hedge because even though they try to make educated decisions about how the stock market will perform, in the end it’s still guessing. Hedging is insurance against those guesses. Even though hedging remains a mystery to many novice investors, it’s not that hard to start implementing the practice, making it a no-brainer for anyone who wants to get more serious about investing. Talk to your financial advisor about the best ways to get involved. You might be surprised at how much more secure you’ll feel in your portfolio once you get set up.

By Zina Kumok, Contributor, Investopedia.com

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