What Is Hedging and How Does it Benefit Traders and Investors?

A hedge is an investment strategy employed to mitigate potential losses or gains that may occur in conjunction with another investment. This strategy can be implemented using a variety of financial instruments, including stocks, exchange-traded funds, insurance policies, forward contracts, swaps, options, various over-the-counter products, derivatives, and futures contracts.

The establishment of public futures markets in the 19th century aimed to facilitate transparent, standardised, and efficient hedging of agricultural commodity prices. Since their inception, these markets have broadened to encompass futures contracts that address the hedging of values related to energy, precious metals, foreign currencies, and fluctuations in interest rates.

Evolution

Hedging is a financial strategy that involves taking a position in one market to offset and mitigate the risks associated with a position in a contrary or opposing market or investment. The term “hedge” is derived from the Old English word “hecg,” which originally referred to any type of barrier or enclosure, whether natural or artificial. The earliest known use of “hedge” as a verb meaning “to dodge or evade” dates back to the 1590s, while its application in the context of “insuring oneself against loss,” particularly in betting, originated in the 1670s.

Hedge-Investment Duality 

The concepts of optimal hedging and optimal investments are intrinsically linked. It is demonstrable that what constitutes an optimal investment for one party may serve as an optimal hedge for another, and vice versa. This relationship can be explained through a geometric framework that represents probabilistic market views and risk scenarios. In practice, the hedge-investment duality is closely associated with the widely recognized notion of risk recycling.

Examples:

Agricultural price

A typical hedger is a commercial farmer whose profits are affected by the fluctuating market values of crops like wheat, driven by supply and demand dynamics. When deciding to plant wheat, the farmer faces risks: if prices rise by harvest, he profits, but if they drop, he loses money.

To manage these risks, the farmer can enter forward contracts and agreements to sell a specified amount of wheat at a fixed price on a future date. This locks in the price but comes with risks, such as low yields requiring the farmer to buy additional wheat to fulfil the contract or missing out on the benefits of potential price increases. There’s also a chance that the buyer may default on payment or try to renegotiate the contract.

Futures contracts provide another hedging option with several advantages over forward contracts. They are standardized, traded on exchanges, and guaranteed by clearing houses, enhancing liquidity. The farmer can sell futures contracts to hedge against price drops without committing to a single buyer or a set delivery date.

As the delivery date approaches, the spot price of wheat and the futures prices converge. If prices decrease, the farmer profits from his short position in the future, offsetting any revenue loss in the spot market. Conversely, if prices rise, he may incur losses in futures but benefit from higher spot market prices. This flexibility allows the farmer to trade on the market and sell his wheat where he chooses after harvest.

Stock price

A common hedging technique in finance is the long/short equity strategy.

A stock trader believes that Company A’s stock price will rise over the next month due to its efficient widget production. They plan to buy shares of Company A, thinking they are undervalued. However, since Company A operates in a volatile industry, there’s a risk that external events could negatively impact all stocks in that sector.

To hedge against this industry risk, the trader decides to short sell shares of Company B, a weaker competitor, for an equal value.

On the first day, the trader’s portfolio includes:

• Long 1,000 shares of Company A at $1 each
• Short 500 shares of Company B at $2 each

This gives equal positions of $1,000.

On the second day, favourable news boosts stock prices: Company A rises 10% while Company B increases by 5%. The trader realizes a $100 gain from Company A and a $50 loss from Company B.

By the third day, negative news about widgets causes a 50% crash in stock prices. Company A loses less than Company B:

• Company A value drops to $550, resulting in a $450 loss.
• Company B value drops to -$525, resulting in a $475 profit.

Without the hedge, the trader would have lost $450, but the hedge nets a profit of $25 during the market downturn.

Stock/futures hedging

The introduction of stock market index futures has provided a second means of hedging risk on a single stock by selling short the market, as opposed to another single or selection of stocks. Futures are generally highly fungible and cover a wide variety of potential investments, which makes them easier to use than trying to find another stock which somehow represents the opposite of a selected investment. Futures hedging is widely used as part of the traditional long/short play.

Hedging employee stock options

Employee stock options (ESOs) are securities issued primarily to a company’s executives and employees. These options tend to be more volatile than regular stocks. One effective way to reduce the risk associated with ESOs is to sell exchange-traded call options and, to a lesser extent, purchase put options. While companies generally discourage hedging ESOs, there is no formal prohibition against it.

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