The verb hedge means to protect against loss by taking counterbalancing measures. For investors, it means entering into a transaction to protect an existing investment(s) and entails an important risk management technique called “portfolio insurance”.
A hedge involves taking an offsetting position in the same or related security, such as the purchase of an option or futures contract or short selling the underlying security, all to reduce the risk of an adverse market price movement in the future.
Options, the most common hedging instrument, are a security that conveys the right - not the obligation - to engage in a future transaction on some underlying security. For example, a call option provides the right to buy a certain number of units of a security at a set strike price at some time on or before option expiration, while a put option provides the right to sell units at a specified price and time. If the option holder exercises the option, the party selling the option must fulfill the contract terms. The leverage afforded by options can create outsized returns and speculators create a viable options market for risk hedgers.
A nervous investor can hedge against a future stock market decline by purchasing market index puts. Market index puts increase in value as the market declines, counteracting the unrealized loss in the portfolio.
Covered call writing is an effective option hedging technique for concentrated investments. It involves selling (“writing”) a call on the underlying security owned by the investor and receiving the option premium as income. If the price of the underlying security remains stable or declines, the option income cushions the loss and/or provides additional investment return.
We help our clients develop the right portfolio risk management strategy using option-based hedging techniques when appropriate.
