Although it may sound like the term "hedging" refers to something that is done by your gardening-obsessed neighbour, when it comes to investing hedging is a useful practice that every investor should be aware of. In the stock market, hedging is a way to get portfolio protection—and protection is often just as important as portfolio appreciation.
Hedging is often discussed more broadly than it is explained. However, it is not an esoteric term. Even if you are a beginning investor, it can be beneficial to learn what hedging is and how it works.
What Is Hedging?
The best way to understand hedging is to think of it as a form of insurance. When people decide to hedge, they are insuring themselves against a negative event's impact on their finances. This doesn't prevent all negative events from happening. However, if a negative event does happen and you're properly hedged, the impact of the event is reduced.
In practice, hedging occurs almost everywhere. For example, if you buy homeowner's insurance, you are hedging yourself against fires, break-ins, or other unforeseen disasters.
Understanding Hedging
Hedging techniques generally involve the use of financial instruments known as derivatives. The two most common derivatives are options and futures. With derivatives, you can develop trading strategies where a loss in one investment is offset by a gain in a derivative.
A classic example of hedging involves a wheat farmer and the wheat futures market. The farmer plants his seeds in the spring and sells his harvest in the fall. In the intervening months, the farmer is subject to the price risk that wheat will be lower in the fall than it is now. While the farmer wants to make as much money as possible from his harvest, he does not want to speculate on the price of wheat. So, when he plants his wheat, he can also sell a six-month futures contract at the current price of $40 a bushel. This is known as a forward hedge.
Futures and Hedging
A futures contract is a standardized, legal agreement to buy or sell an asset at a predetermined price at a specified time in the future. At this specified date, the buyer must purchase the asset and the seller must sell the underlying asset at the agreed-upon price, regardless of the current market price at the expiration date of the contract. Underlying assets for futures contracts can be commodities–such as wheat, crude oil, natural gas, and corn–or other financial instruments. Futures contracts–also just called futures–are sometimes used by corporations and investors as a hedging strategy. Hedging refers to a range of investment strategies that are meant to decrease the risk experienced by investors and corporations.
Some corporations that are producers or consumers of commodities use futures contracts to reduce the risk that an unfavourable price movement in the underlying asset–typically a commodity–will result in the corporation having to face unexpected expenses or losses in the future.
When an investor uses futures contracts as part of their hedging strategy, their goal is to reduce the likelihood that they will experience a loss due to an unfavourable change in the market value of the underlying asset, usually a security or another financial instrument. If the security or the financial instrument typically experiences a lot of volatility, an investor may be more likely to purchase a futures contract.
Using Futures Contracts to Hedge
When corporations invest in the futures market, it is usually because they are attempting to lock in a more favourable price in advance of a transaction. If a corporation knows that it has to purchase a specific item in the future, it may decide to take a long position in a futures contract. A long position is the buying of a stock, commodity, or currency with the expectation that it will rise in value in the future.
Advantages of Futures Over Options
Futures Are Highly Leveraged Investments
To trade futures, an investor has to put in a margin — a fraction of the total amount (typically 10% of the contract value). The margin is essentially collateral that the investor has to keep with their broker or exchange in case the market moves opposite to the position they have taken and they incur losses. This may be more than the margin amount; in which case the investor has to pay more to bring the margin to a maintenance level.
What trading futures essentially means for the investor is that they can expose themself to a much greater value of stocks than he could when buying the original socks. And thus, their profits also multiply if the market moves in his direction (10 times if margin requirement is 10%).
Future Markets Are Very Liquid
Future contracts are traded in huge numbers every day and hence futures are very liquid. The constant presence of buyers and sellers in the future markets ensures market orders can be placed quickly. Also, this entails that the prices do not fluctuate drastically, especially for contracts that are near maturity. Thus, a large position may also be cleared out quite easily without any adverse impact on price.
In addition to being liquid, many futures markets trade beyond traditional market hours. Extended trading in stock index futures often runs overnight, with some futures markets trading 24/7.
Commissions and Execution Costs Are Low
Commissions on future trades are very low and are charged when the position is closed. The total brokerage or commission is usually as low as 0.5% of the contract value. However, it depends on the level of service provided by the broker.
Speculators Can Make Fast(er) Money
An investor with good judgment can make quick money in futures because essentially, they are trading with 10 times as much exposure than with normal stocks. Also, prices in the future markets tend to move faster than in the cash or spot markets.
A word of caution, however: Just as wins can come quicker, futures also magnify the risk of losing money. That said, it could be minimized by using stop-loss orders. Because futures are highly leveraged, margin calls might come sooner for traders with wrong-way bets, making them potentially a riskier instrument than a stock when markets move fast.
Futures Are Great for Diversification or Hedging
Futures are very important vehicles for hedging or managing different kinds of risk. Companies engaged in foreign trade use futures to manage foreign exchange risk, interest rate risk by locking in a interest rate in anticipation of a drop in rates if they have a sizable investment to make, and price risk to lock in prices of commodities such as oil, crops, and metals that serve as inputs. Futures and derivatives help increase the efficiency of the underlying market because they lower unforeseen costs of purchasing an asset outright. For example, it is much cheaper and more efficient to go long in S&P 500 futures than to replicate the index by purchasing every stock.
Future Markets Are More Efficient and Fairer
It is difficult to trade on inside information in future markets. For example, who can predict for certain the next Federal Reserve's policy action? Unlike single stocks that have insiders or corporate managers who can leak information to friends or family to front-run a merger or bankruptcy, futures markets tend to trade market aggregates that do not lend themselves to insider trading. As a result, futures markets can be more efficient and give average investors a fairer shake.
Futures Contracts Are Basically Only Paper Investments
The actual stock/commodity being traded is rarely exchanged or delivered, except on the occasion when someone trades to hedge against a price rise and takes delivery of the commodity/stock on expiration. Futures are usually a paper transaction for investors interested solely on speculative profit. This means futures are less cumbersome than holding shares of individual stocks, which need to be kept track of and stored someplace (even if only as an electronic record). Companies need to know who owns their shares in order to pay out dividends and to record shareholder votes. Futures contracts don't need any of that record keeping.
Short Selling Is Easier
One can get short exposure on a stock by selling a futures contract, and it is completely legal and applies to all kinds of futures contracts. On the contrary, one cannot always short sell all stocks, as there are different regulations in different markets, some prohibiting short selling of stocks altogether. Short selling stocks requires a margin account with a broker, and in order to sell short you must borrow shares from your broker in order to sell what you don't already own. If a stock is hard to borrow, it can be expensive or even impossible to short sell those shares.
The Bottom Line
Futures have great advantages that make them appealing for all kinds of investors — speculative or not. However, highly-leveraged positions and large contract sizes make the investor vulnerable to huge losses, even for small movements in the market. Thus, one should strategize and do due diligence before trading futures and understand both their advantages as well as their risks.
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