Why Hedging Is Important

If you ask most retail investors, most will tell you that they only know how to make money one way, that is, take profit when the asset price rises. What happens when one's prediction goes opposite way? One simply loses money. During stock market downturn, it is not difficult to find that many investors sell on panic mode, either to minimize or to cut losses. In truth, no matter how good you think you are in picking the best stocks, chances are your prediction may turn out the other way due to various factors such as false information, poor market sentiment or other external factors driven by politics, change of governmental policies or regulations, etc.

It is important therefore to hedge against your investments, or simply put, to reduce your exposure risk in any particular investment instrument. Remember the game of blackjack in a casino? A card player may opt to purchase an "insurance"against banker's cards having a blackjack and therefore stand to minimize losses if banker's cards do turn out to be such. The same applies to investment trading. An investor can hedge against its investments by separately entering into a hedging instrument such as options and futures, so that he protects his investments against unforseeable losses in the event the market movement goes the opposite direction. This is commonly practiced by institutional investors of money market instruments and corporations who have significant exposure to foreign currency and commodity such as crude oil and other raw materials. For example, if one expects crude oil prices to rise above USD70 per barrel when current price is USD50, an airline company may decide to enter into a options contract at say USD60 to hedge its position on crude oil to prevent further cost escalation. If actual price exceeds USD60, one stands to gain due to cost savings. However, if price falls below USD60, one stands to lose as he now is required to pay a higher price for the commodity.

In stocks, one may also use derivative instruments such as options or futures to hedge against one's investment portfolio. Technically, to hedge one would invest in two securities with negative correlations. The idea of hedging is therefore not to make more money but essentially to reduce one's exposure risk or to reduce losses, in the event of adverse market movement. Bear in mind that if the investment one is hedging against makes money, one will have typically reduced the profit that you could have made, and if the investment loses money, one's hedge, if successful, will reduce that loss.

In an adverse market condition such as the current stock market turbulence caused by US subprime and credit woes, an investor who has had a proper hedging technique would have safeguard his or her investments by reducing the amount of potential losses.

The downside of hedging is that often it is a more complex tool and it is never easy to achieve a perfect hedge. Do not rule out the possibility that things could still go wrong even with hedging. Just bear in mind that the objective of hedging is to reduce losses over one's exposure, not to make more money.

On the flip side, one could also use the above derivative instruments to make a speculative profit rather than hedging. I shall look at speculation vs hedging on another day.