Concerned about your portfolio? To potentially offset losses, some investors hedge their investments through strategies like selling short and buying put options.
Unlike compounding, which can help maximize long-term return, hedging helps limit risk. Even if you believe you know how an investment is going to perform, market movements are generally unpredictable. As a result, some investors hedge to help counter market instability.
There are several ways to hedge an investment. One approach is to offset losses in one investment by purchasing a second investment that is expected to perform in an opposite way. Additional hedging techniques include but are not limited to short selling stocks and buying put options.
When you sell short, you are selling shares that you do not own but you anticipate will fall in price. To sell short, you borrow these shares of stock and then sell them. If the price does indeed fall, you may repurchase the shares at a lower price in the secondary market and realize a profit. This strategy alone can be quite risky, as the stock's price is not guaranteed to fall. You may be required to buy the shares back if they increase in value, and there is no limit to how high the price can climb.
However, short selling can be used as a method of limiting market risk when used in conjunction with a long position in another stock.
For example, if you purchase shares in a strong company you believe will perform well, you can short sell stock in a second company with similar characteristics. If the companies carry approximately the same level of risk and the market experiences a downturn, the short sale can help counter the loss you could face in the stock you purchased outright.
Conversely, if you sell short, and the price of the stock begins to rise, you could be forced to repurchase the shares at a higher price than the shares you sold short. This could result in a loss on the stock. There is also no guarantee your brokerage firm can continue to maintain a short position for an unlimited time period. Your position may be closed out by the firm without regard to your profit or loss. You also need to consider the transaction costs, margin requirements, and margin interest on the transaction.
Another way to hedge risk is through the use of options. As in the previous example, you might be nervous that the value of a stock you've purchased will decline, potentially resulting in a loss. However, instead of short selling a different stock, you can purchase a put option on the stock you own. Buying a put contract gives you the right, but not the obligation, to sell a given number of shares at a predetermined price by or on an expiration date. If the stock falls in value, you can limit your loss by having purchased a put with a strike price lower than your purchase price. In this case, your loss will be limited to the difference between what you paid for the shares and the strike price of the option at which you can sell the shares, plus the amount you paid for the put.
Alternatively, if the stock price rises, you can protect your profit by purchasing a put with a strike price higher than what you paid for the stock. This way, if the stock price falls, you can lock in a profit by selling the shares for more than you paid for them by exercising the put. Keep in mind that this strategy provides only temporary protection from a decline in the price of the corresponding stock. Should the long put position expire worthless, the entire cost of the put position would be lost.
It is important to keep in mind that while hedging is meant to limit risk, there are costs associated with it, and returns are never guaranteed no matter what technique you utilize.