Hedging

Hedging is used to protect a market position against adverse price movements. The idea is to take an offsetting position whose value moves in the opposite direction, so that losses on one side are at least partly balanced by gains on the other.

How hedging works

A fund manager, for example, can hedge a portfolio against a correction in the stock markets by opening short positions in suitable derivatives such as futures. If share prices fall, the losses on the equity positions are offset by the gains on the short positions in the futures market.

Example: a fund holds US shares worth $1,000,000 and sells stock index futures of roughly the same value. If the market falls by 10% and the portfolio moves in line with it, the shares lose around $100,000, while the short futures position gains around $100,000.

Companies use hedging in the same way to manage business risks. By hedging with oil futures, for example, airlines can lock in low fuel prices and gain greater certainty for their planning. Exporters and importers protect themselves against exchange rate fluctuations with currency forwards or futures.

Advantages and limits

Hedging reduces risk, but it comes at a price. It involves costs such as fees, spreads or option premiums, and it limits not only losses but also potential gains: if prices rise instead, the gains on the hedged position are largely cancelled out by losses on the hedge. In addition, a hedge rarely works perfectly, because the position and the hedging instrument seldom move exactly in line.

Hedging vs. hedging a position

Hedging in this sense means protecting portfolios or business risks with an offsetting position, usually in derivatives. Hedging a position, on the other hand, describes the narrower practice of securing a single open trade – for example by a partial sale or by moving the stop-loss to the entry price.