What is Hedging: Definition, How it Work, Examples

Hedging is a strategy that seeks to limit risk exposures in financial assets.

In the stock market, hedging is a strategy used to safeguard your portfolio, and this protection is as crucial as portfolio growth.

While hedging is frequently mentioned, it’s not always well explained. Despite its seemingly complex nature, hedging is a straightforward concept. Even for novice investors, understanding what hedging is and how it functions can be advantageous.

Definition and Purpose of Hedging

Hedging is defined as a way to minimize financial risks, especially against sudden changes in value of investments. Primarily, the goal here is to mitigate risk by holding an alternative position in another asset to offset losses faced by the primary holding. 

The purpose of hedging is to minimize risk of financial loss. There are different ways to engage in hedging. 

What do you mean by hedging?

Hedging is a financial strategy used by organizations and individuals alike. In essence, it is used to minimize downsides even at the cost of high returns to ensure fiscal stability. 

Importance of Risk Management in Investments

Risk is an integral part of any investment. There would be no upside potential if there was no risk involved but fund managers need to come up with a way to make sure that they achieve their fiscal goals even if it stifles further profits. Investment institutions often prioritize steady, healthy growth over volatility and unpredictability so hedging is a necessary tool. 

In addition to big investment managers, hedging is also important for retail investors. They should study different hedging strategies to manage risks of their own. Hedging shouldn’t be seen as an exclusive tool for big-money players. 

Basic Concepts of Hedging

What is a Hedge?

A hedge is a financial strategy to help reduce/eliminate risks on investments. Hedging can be beneficial for businesses and individuals alike. It can help them remain unaffected by the volatility of national economies and markets. 

How Hedging Works

What is an example of hedging?

As a hedging example, we have a farmer who has a peanut crop and he is worried that the price of his produce may fall. One of the things he can do is open a peanut futures contract with the end price much higher so the other party is bound to buy the contract if prices do fall. In this way even if the price of his produce falls, he can sell the futures contract at a higher rate, thus offsetting his losses. 

Options Hedging

An options contract is different from a futures contract as it allows the buyer to have the right to buy/sell an asset at a fixed price in the future and not the obligation. A call options contract is a buying contract, while a put options contract is a selling contract. Companies use options contracts as a kind of insurance to save themselves from the risks of the market. 

Protective Puts and Covered Calls

A protective put gives the buyer the right to sell to hedge against the downside volatility of the stock market. This happens when the investor is still bullish about the future of the investment but intends to protect himself from downside price action. A put option puts caps on any immediate losses on the investment. 

Futures Hedging

A futures contract can be used for hedging purposes. It is an agreement between two parties to buy or sell an underlying asset at a previously set fixed price at a specific future date. However, a regulator futures contract isn’t popularly used for hedging purposes. 

Forward contracts are specific futures contracts between two parties that allow a lot of customizability as compared to a regular exchange futures contract. 

Use of Futures Contracts

Futures contracts are often used for hedging purposes. If you are a farmer with a certain produce lets say corn and you want to protect yourself if the price goes down. You open a short futures contract at a higher price. So, even if the crop’s value goes down, you can sell your harvest at a higher price, ensuring you don’t end up at a loss. 

Swaps

Swaps are a useful financial tool for hedging. In essence, swaps are private agreements between two parties. These entail pre-set agreements to exchange certain assets or investments to protect against volatility. 

Interest Rate Swaps

Small changes in interest rates can spell disaster for companies. If a company borrows $50 million at 4.5% veritable (variable) interest rate, even a 0.5% change can disrupt the entire cash flow. To avoid this, they use interest rate swaps. They agree to pay fixed interest rate, often slightly higher to another company and they would be liable for any further changes in the rate. It basically passes the buck to the other organization. 

Currency Swaps

Currency swaps are widely used for hedging purposes. They basically involve two organizations to exchange cash flows at specific times in the future. Imagine a company operating in China and earning in Chinese Yuan (CNY), but much of its expenses are USD-based. They are wary of the CNY losing ground against the USD in the near future. This could jeopardize their business, so they enter an agreement with a bank or any other institution to fix the exchange rate at that point in time. Alternatively, they can borrow USD at a fixed interest rate and then pay it back later on. 

Reasons to Hedge

Mitigating Potential Losses

The primary goal when it comes to hedging is mitigating any potential losses arising from excessive volatility. Hedging is done to improve predictability of a company’s financial future even if it comes at the cost of potential gains. 

Managing Overconcentration

Hedging allows users to reduce reliance on a single asset or sector. If you are heavily exposed to one sector’s volatility and you need financial clarity, you can hedge through diversification. You can also hedge against losses while still betting on positive price actions. 

Tax Considerations

Using the right hedging strategy can help reduce your tax liabilities. Tax requirements can be complex overall, and hedging can actually increase your tax payments, so it is best to consult a tax advisor for this purpose. 

Business Examples (e.g., Airlines Hedging Fuel Costs)

Jet fuel is a major expense for many airlines, and the cost of fuel is volatile. Airlines hedge through futures contracts, options contracts, or swaps. The primary goal is to keep the cost of their fuel stable so their financial projections don’t suffer. If the fuel prices drop, they don’t benefit from them, but they are saved from the upside price action. 

Hedging with Different Instruments

Different financial instruments can be used for hedging purposes. Primary examples include:

Using Options for Hedging

Options contracts are often used for hedging purposes. An option contract gives the buyer the right to buy/sell an underlying asset at a fixed time in the future. The asset can be anything from a stock, bond, or a commodity. 

Options contracts are used in two approaches:

• Protective puts are when an investor is involved in a certain stock and wants to protect their position. By buying a put contract, he can enter a strike price below an affordable level of risk. If the index falls within a stipulated expiration date, the investor gains the right to sell it. This protects them from the downside risk. 
• Covered Calls are another options contract that allows investors to generate some passive income while sacrificing some upside price action in the process. A covered call involves setting a price higher than the current price action with a premium involved. If that price level is achieved, the buyer has the right to sell his underlying asset at that price while also pocketing the premium. 
• Hedging with Futures Contracts

Futures contracts are an effective hedging tool the volatilities of the market. A futures contract is an agreement between two parties to buy or sell a contract at a specified time in the future. However, unlike the options contracts, futures contracts obligate the two parties to see things through. 

Two ways to use futures contracts:

• Short futures hedging aka short hedging is used by investors who want to protect themselves against a potential price decrease. They set a futures contract with an expiration date right around the time they plan to sell. This contract is in the opposing direction and cancels the downsid price action of the underlying asset. 
• Long hedging is used by investors to protect against a potential price increase at the time of their selling. They open a futures contract with a price lower than anticipated at the time of selling. This allows them to hedge against a potential increase in price, thus keeping the books steady. 
• Swaps and Their Uses in Hedging

Swaps are extensively used by big companies for their hedging goals. A swap is a bi-party agreement to exchange cash flows at a predetermined time in the future with stability in mind. 

Swaps are used in two ways for hedging purposes:

• Interest rate swaps are used by companies to keep interest rates steady through agreements with another company. They enter an agreement with a financial institution, usually a bank, to pay a fixed rate while the bank takes on the responsibility of having a variable rate in the future. This protects companies from the volatility of the central bank policy rate. 
• Currency swaps or hedging is when two parties enter an agreement to have a fixed exchange rate between two currencies. The other party absorbs the risk of the volatility, leaving the company’s books more stable. 
• Other Derivative Instruments

Other popular hedging tools include forward contracts, caps and floors, collars, credit default swaps, and Forward Rate Agreements (FRA). 

Advantages and Disadvantages of Hedging

Useful benefits of hedging include:

• Protection against downside/upside price action as market volatility is a dangerous situation for a company to be exposed to. They have specific targets to be met, and they cannot risk their operations by jeopardizing their cash flows or target prices. 
• Improved predictability means that companies can plan accordingly and maintain a strong financial position. This way, they can expect clearer returns from their investments. 
• Improved Cash Flow can help companies achieve financial milestones like expenses. This is especially useful for firms with reliance on multiple currencies due to the scale of their operations. 
• Potential Drawbacks and Costs

Possible drawbacks of hedging include:

• High premiums and fees as futures contracts require margins, options contracts require premiums, and swaps have various fees associated with themselves as well. These costs can be substantial, and they are the price a company has to pay to bring some kind of stability. 
• Upside potential is limited as the company is prioritizing steadiness over potential upside price action. This is particularly detrimental for investments that have a great upside potential and they can locked into prices much lower than the eventual peak. 
• The risk of miscalculation is high. The complex nature of futures contracts, swaps, options and other hedging tools means that there are a lot of variables involved. This can lead to actual financial losses if used poorly and there have been many examples in this regard. Miscalculation can be deadly for a company. 
• Poor transparency as swaps in particular are private agreements between parties regarding exchange rates or interest rates. Since they are officially secret, the market is unaware of these agreements and it becomes difficult to plan when it comes to risks posed by them. 
• Scenarios Where Hedging Might Be Ineffective

Hedging is an effective tool for maintaining order and predictability. However, there are certain scenarios in which it is actually detrimental to engage in conventional hedging techniques. They include:

• High Volatility: Options with short expiry dates and slightly lower strike prices can be detrimental in a volatile market. The cost of premiums especially can fluctuate considerably and that can actually cause financial harm to the company. 
• Difficulty Against Hedging a Market Change: Hedging is only effective when used for quantifiable and easily calculated scenarios. Not everything can be hedged effectively, and that is a big drawback for many sectors. 
• Short-term Changes: Hedging is used by companies as a long-term tool. Short-term price movements are difficult to hedge against, and they can result in monetary losses. It is best to stick to hedging alternatives like stop-loss orders and diversification for this purpose. 
• Counterparty Risk: Swaps in particular have a major counterpart risk. For example, bank agrees with a company regarding a fixed exchange rate and it is not able to fulfill its obligations. This may result in a severe liquidity crisis that can impact entire industries and prompt a bailout from the government, but not always. Sometimes banks are allowed to fail. Hedging should keep this in mind. 
• Basis Risks: This is when a company plans to buy/sell an underlying asset using futures or options contracts. However, the price of an asset is not the same everywhere and there are countless variable involved like for example the quality of a produce or raw material. This basis risk results in price fluctuations even with the hedging in place, making it less effective than it really is. 
• Inaccurate predictions are problematic overall. 

Hedging in Different Markets

Stock Market Hedging

Hedging is extensively used in the stock market to avoid financial losses on your investments. Typical examples of stock market hedging include:

• Options: Options can be used in a variety of ways for stock market hedging. A put option contract is employed to reduce downside risk in an investment. For example, if you have a stock and you want to enjoy its upside potential but are wary of any potential losses. You choose a specific strike price with an expiry date. If the stock falls to that price, you have the right to sell it at that price, thus minimizing your losses. Another way to use options is to have a collar strategy in place that uses both put options and call options to achieve stability. If the stock price tumbles, it is liquidated, and if it rises, you earn dividends in the form of a premium. However, it is much less effective than simply owning the asset for the same amount of time if it keeps posting healthy gains. 
• Shorting: Shorting or short selling is an advanced, risky strategy used often by big money players when they believe a particular stock or underlying asset is going to post losses. It involves the short seller borrowing money to sell the stock immediately and then promising to buy it back at a much lower price. If the value does drop that much, the short seller buys it back and pockets the difference. However, it is an extremely risky strategy and often has no place in regular hedging activity. 
• Inverse Exchange Traded Funds (ETFs): An inverse ETF, as the name suggests, is a stock traded product that is designed to perform inversely to the underlying asset. The ETF issuer achieves this by either shorting the asset or other derivatives. Using this tool, hedging is quite simple as you just need to buy the asset and its inverse ETF in the market. Since both of them move in opposing directions, the net price effect is zero, and your funds remain stable. However, not all assets offer inverse ETFs, and this is only done when investors are wary of increased volatility affecting their books. 
• Commodity Market Hedging

The commodities sector is quite volatile overall due to the global supply/demand situation, which is, in turn, affected by geopolitical and natural events. This is why many companies and even individuals reliant on commodities engage in hedging exercises to achieve some measure of stability. They include:

• Options: For producers, hedging can be achieved simply through a put options contract. If they are wary of a potential price decline in a commodity, they can simply buy a put options contract, and if it falls below the set strike price, they have the right to sell it at that price. The advantage of a put options contract is that it saves you from downward price action while allowing upward movement. Consumers who wish for the price to remain below a certain level can start a call options contract. If the value of the underlying commodity starts to rise and reaches the strike price, they have the right to buy it at that price. 
• Futures: For producers, hedging is achieved by setting up a futures contract with an expiration date close to the production/harvest time. If the producer fears the spot price can drop to a certain level, they can open a futures contract at a higher price. So, even if the price falls, they can offset potential losses by selling it at a higher price because of the obligation of the futures contract. For consumers, they need a stable price and cannot afford steep price increases. They open futures contracts at a slightly higher price, and then they are obligated to buy at that price, which works well in their interest. This protects them from steep jumps in the price of the commodity. 

Forex Market Hedging

Forex market hedging uses the currency market to achieve some sort of stability. The forex market operates 24/7 and can get quite volatile at times, but it is necessary for companies to have cash reserves, so there is no way out of it than to hedge it effectively to avoid price fluctuations. Effective forex hedge practices include:

• Options: Put options allow users to sell a currency pair at a lower price to avoid potential losses. If a currency pair, like the GBP/USD, is at risk of a fall, EUR holders can open a put options contract which gives them the right to sell it if the index falls below a certain level at a certain point in time. So, even if the EUR/USD pair falls they got it covered with the futures contract. 
• Forward contracts: These are essentially customized futures contracts. It involves two parties agreeing to a fixed exchange rate in the near future. Both parties are obliged to see through the contract. 

Hedging in Cryptocurrency Markets

Cryptocurrency markets are known to be extremely volatile, so hedging is a popular choice among crypto investors. However, hedging is more suitable for less volatile markets. They achieve it by using the following tools:

• Options Contracts: Options contracts come in the form of put (sell) contracts and call (buy) contracts. Put contracts allow investors downside risk protection by giving them the right to sell at a predetermined price lower than the spot price. Call options contract allows investors to earn premiums if the underlying crypto’s price increases to a certain level in the near future. 
• Futures Contracts: Crypto traders can protect themselves from a market dump by engaging in long position protection. You can engage in a sell futures contract to offset some of the losses. Alternatively, if traders believe crypto is going to perform poorly, they can short-sell it and benefit from it. 
• Perpetual Swaps: Perpetual swaps are somewhat similar to futures contracts but they don’t have an expiry date. They mandate constant updating of margin to keep the position open, otherwise they are liquidated. They can also be used for both long and short positions. 
• Stablecoin Conversions: If the crypto market is volatile, traders can convert to a USD-pegged digital currency to have a short-term hedge against it. However, some stablecoins can have counterparty risks. 
• Diversification: Spreading investments across a range of cryptocurrencies is a popular option for traders. Losses in some crypto can be minimized by potential gains in other examples. 

Case Studies and Practical Examples

Hedging is an effective tool for producers, consumers, and speculators. Here is an example of an effective hedging strategy in each of these scenarios:

• Southwest Airlines and Fuel Costs: Back in the early 2000s, major American airline Southwest Airlines is lauded as a successful example of hedging fuel prices effectively. Instead of depending heavily on the market’s fluctuations, Southwest Airlines decided to enter long-term futures contracts to buy jet fuel at fixed prices. This was a success as oil prices started to rise significantly after the US invasion of Iraq in 2003 and rose to all-time highs in just five years, causing massive increases in fuel costs. Southwest was able to avoid all this trouble and remain profitable, thus increasing its long-term position in the airline industry.
• Wheat Farmers and Harvest Prices: Wheat farmers across the United States have had fairly impressive success by hedging their produce against potential price drops during harvest time. They opened a futures contract with a higher price tag and set it to expire around harvest time. So, even if the price drops, they will recover it with the help of their future contract. They only needed to pay the margin price, which can be significant, but they managed well enough. 
• Analysis of Successful and Unsuccessful Hedges

Hedging is an effective strategy to have some level of support against market fluctuations. However, hedging can go disastrously wrong at times. Here are a few real-world examples of unsuccessful hedging practices:

• Airline Poorly Hedges Against Fuel Costs: An aggressive airline decided to hedge fuel costs based on pre-determined price calculations. They estimated that the fuel prices would keep on increasing in the next decade, and they locked it in, thinking they were saving money. However, what happened instead was the price took a major tumble in the coming years. This resulted in the airline operating at a much lower profitability and higher operating costs than its competitors, who didn’t hedge heavily. This resulted in its stock performing poorly, and eventually, it was absorbed by its competition. 
• Nickel Giant Loses Money Short-selling: Major Nickel manufacturing company Tsingshan from China famously misused options contracts to hedge against a fall in Nickel prices. The price rose sharply, resulting in margin calls for the company at an unprecedented level. All in all, it lost billions of dollars with the help of this ineffective hedge.  
• GameStop’s Short Selling Goes Horribly Wrong: GameStop stock (GME) was infamously shorted by Melvin Capital, Citadel LLC, and Point 72 Asset Management, among others. However, a group of online investors started a social media trend to teach them a lesson and inflated the price of the stock considerably, leading to massive losses for these capital firms. All in all, the big funds lost $6 billion due to this social media-inspired frenzy. 

So, the key takeaway from this saga is that hedging is not a fail-safe strategy. The future is unpredictable and can cause companies to lose their worth quickly if they aren’t careful. Just like successful hedging practices, there are many unsuccessful hedging practices as well that can result in losses worth billions of dollars. 

Hedging for Individual Investors

For retail investors, it is better to engage in multiple hedging techniques. There is no one-size-fits-all situation. Speculators need to understand this basic principle. The best way to engage in hedging is diversification, the importance of cash reserves, stock options but in limited amounts, and using simple exchange trades like stop-loss. 

Cost-Effectiveness and Complexity

For retail investors, the cost-effectiveness of hedging may not make sense everytime. Big fund managers have a lot of capital to play with and even if hedging margins and premiums take up money, they are prepared to do so. So, retail investors need to keep costs in mind while engaging in hedging exercises. 

Another important aspect is complexity. Big funds employ hundreds of highly skilled workers to engage in complex calculations regarding the future. They use these numbers to plan effective hedging strategies, and even they are wrong a lot of the time. Retail investors simply don’t have enough resources to engage in these statistical approaches, and many don’t have the skillset to make the right decisions. 

Alternatives to Hedging (e.g., Diversification)

The positive side of this argument is that there are alternatives to options and futures contracts for retail investors. They include:

• Diversification
• Long-term investment goals
• Dollar Cost Average (DCA)
• Consider low-cost S&P 500 Funds
• Invest in scarce assets
• Invest in financial education

Educational Resources and Further Reading

Recommended Books and Articles on Hedging

• More Money Than God by Sebastian Mellaby 
• Hedging: Principles, Practices, and Strategies for Financial Markets by Joseph D. Koziol
• When Genius Failed: The Rise and Fall of Long-Term Capital Management by Roger Lowenstein

Online Courses and Tutorials

• On Coursera 
• On Udemy 

Tools and Software for Hedging Analysis

• MetaTrader 4 and 5 (MT4 & MT5)
• Backstop
• NorthStar Risk Corp

Conclusion

Hedging helps investors and traders reduce risk by taking an opposite position to their main investment. This means if the main investment loses value, the hedge gains value, and vice versa, like an insurance policy for investments. Hedging can be done with similar assets or by diversifying, but the most common method is using derivatives like futures, forwards, or options contracts.

Frequently Asked Questions

How do you hedge in trading?

Popular ways to hedge in trading include futures contracts, options contracts, and swaps. 

What is hedging in banking and finance?

In banking and finance, hedging is largely related to interest rate swaps in which organizations engage in pre-determined rate swaps.

Braden Chase

Braden Chase is an investor, trading specialist, and former research specialist for Forex.com who helps aspiring investors develop the confidence and habits they need to make an income from the market. Braden has served as a registered commodity futures representative for domestic and internationally-regulated brokerages and has also spoken & moderated numerous forex and finance industry panels across the globe.

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