The financial industry is littered with jargon that many find difficult to unpack. Investors who understand these terms can communicate more effectively with their advisors, gain a clearer appreciation of financial media, and feel more confident in their financial plan. That’s why DreamWork Financial Group strives to educate our clients on common investing terms – like “hedging.”
What is hedging?
Hedging is an investing strategy that includes buying or selling a security with the goal of reducing the risk of loss associated with another investment. This strategy can be particularly beneficial in volatile markets. By nature, hedging is a strategy that sacrifices some gains for the benefit of limiting losses.
You can think of hedging like purchasing an insurance policy. If you live in an area prone to flooding, for example, you will typically purchase flood insurance. While you can’t prevent a flood, you can “hedge” against the losses associated with one. The same is true with investments. If you invest in a high-risk asset, you can implement hedging strategies to minimize the damage to your portfolio if losses occur.
Hedging can be accomplished in several ways. You could purchase securities that typically move in opposite directions, or you could purchase securities specifically designed to hedge against a particular type of loss.
Hedging Through Diversification
Diversification is an investing strategy where investors purchase securities that are negatively correlated, meaning that they typically react to market conditions in opposing ways. With negatively correlated stocks, when one loses value, the other is expected to appreciate.
Hedging through diversification could include purchasing a stock, a mutual fund, or an ETF that is negatively correlated with a position that you currently hold. For example, if you are heavily invested in oil, you could purchase airline stocks as a hedge since lower gas prices typically mean more profits and higher stock prices for airlines.
The downside of hedging through diversification is reduced gains if the hedge is not needed. Continuing with the oil and airline example, if oil stocks performed well, the airline stocks in your portfolio would be expected to tumble. These losses would offset some of the gains from your oil stocks. While hedging can help reduce risk, it can also diminish reward depending on the cost of the strategy and the degree to which you implement it.
Hedging With Derivatives
Derivatives are securities whose prices are derived from the value of underlying assets. These include options, swaps, futures, and forward contracts. Individual investors are most likely to be familiar with options contracts. These give the owner of the contract a right to buy or sell a security at a specified price.
Investors can purchase options contracts to protect against losses in a particular stock, industry, or market condition. For example, if you purchased a stock at $10 per share and wanted to protect against significant losses, you could purchase an option contract giving you the right to sell the stock at $9 per share in the future. This strategy would limit your losses to $1 per share, even if the value of your stock dropped more substantially.
Like hedging through diversification, derivatives include a risk-reward tradeoff. Typically, a derivative’s price corresponds to the amount of protection that it offers. Therefore, the more risk you want to prevent, the more you must spend to do so.
A hedging strategy, whether accomplished through diversification or derivatives, can help you minimize losses. Unfortunately, most wealth managers reserve advanced hedging strategies for only their wealthiest clients. However, there are financial advisors that provide the same level of service to all their clients, regardless of net worth. These advisors can implement complex strategies, like hedging, even if you don’t have a large portfolio.
Protect Your Investments with Investing Gameplan™ By DreamWork Financial Group
Investing Gameplan™ by DreamWork Financial Group is a unique wealth management program that allows all investors to access custom portfolios and a wide range of investing strategies – like hedging. Investing Gameplan™ is open to all investors, regardless of their account balance. That’s why we say, You Don’t Have to Be Wealthy to Have Wealth Management®.
At DreamWork, our advisors are fiduciaries, meaning they are legally obligated to act in your best interest all the time. To make that possible, our compensation structure eliminates conflicts of interest and ensures that we make more money when you make more money.
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