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Financial Hedging Explained

Everyone has heard the term ‘hedging your bets’, meaning to bet on more than one possible winner in order reduce the chance of losing everything. In fact, the term was originally a financial one, and was only later adopted by the gambling community.

In the oldest meaning of the term, around the 17th century, it meant securing a smaller loan by including it in a larger one, which presumably had its own independent security.

What is ‘Hedging’ Today?

Hedging against investment risks today is actually not unlike ‘hedging your bets’. It involves making a secondary investment of some kind that can be expected to increase in price under the same conditions which would cause your other or primary investment to decrease. Insurance is actually a form of hedging – you invest in both a home and home insurance, so that if the value of your home drops sharply (say it is destroyed or made uninhabitable), then your insurance can be expected to ‘pay off’ instead.

Of course, the devil is in the details, as anyone making an insurance claim knows. It is more than possible to lose both your primary investment and your hedge investment(s) if you choose the wrong ones, or if something truly unexpected happens.

How Does Hedging Actually Work?

Anyone can hedge an investment, but portfolio managers and corporate investment specialists make it into an art form. On the individual investor level, one might invest heavily in realty, but ‘hedge’ that investment by buying bullion or securities which might (and I do mean ‘might’) increase sharply in value in the event of another housing market crash.

On a portfolio level, it is more about assembling a collection of different investments (the portfolio), which are not all vulnerable to the same market risks. A ‘diverse portfolio’ can retain most of its value or even show a net gain even if one or more of its individual investments lose value or fail entirely.

Another strategy is to use ‘negatively correlated instruments’, which just means one that will pay off if a particular price falls, and another that will pay off if that exact same price rises. An example would be buying both options and futures in the same commodity.

An Example of Hedging - The ’Married Put’

Let’s say you want to invest in Company X, but you are worried that prices might fall precipitously. You can invest in an instrument called a ‘put option’, which is essentially just a contract that entitles you to sell the stock at a specific price at a certain time, no matter what its actual market price may be. The put option costs money no matter what, but it gives you options. If your Company X stock falls below your contracted put option price, you can sell it for that much and you haven’t lost everything. If the price never falls that low, or if you believe it will shortly rebound, you do not have to use your option. All you’ve ‘lost’ then was the price of buying the option you didn’t use. This strategy is called a ‘married put’.

Do you Need to Hedge?

We can’t advise you on your individual investment strategy. However, on general principles we can say that the larger your investment portfolio is, the more important it will be to devote some attention to hedging strategies, even if that means simple diversification of assets. Historically, bullion has made an excellent hedge for high-risk investments, but only you can decide how to distribute your risk.


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