How to Hedge Stocks

Hedging involves taking a position in the market with the purpose of reducing risk. This may sound strange to those unfamiliar with the concept, shouldn’t the primary reason for entering the market be to make a profit..? 

In this article, we will explore hedging stocks in detail, look at why investors choose to hedge stocks and demonstrate how to hedge stocks with CFDs!

What Is Hedging?

Before we look at stock hedging and explain how to hedge stocks, what is hedging?

Hedging is a method of attempting to mitigate risk by opening an opposing position in the market. The idea behind this is that potential losses sustained in the main position, will be offset by gains in the opposing position. 

The classic analogy is to think of hedging like an insurance policy against market risk. Much like a homeowner might take out insurance in order to protect their home from fire or burglary, an investor hedges their position in an attempt to control their exposure to risk if the market moves against them.

However, we should be careful about drawing too many parallels between these two concepts. Unlike insurance, there is no fully comprehensive guaranteed hedging strategy. The perfect hedge could be described as one which completely eliminates all risk in a position or a portfolio, but it should go without saying, that when it comes to live trading and investing, there is no such thing as “risk free”.

In reality, hedging is adjusting the trade-off between risk and reward - seeking to reduce the overall risk of an investment whilst also lowering its potential reward. The most common way of doing this in the world of investment is by using financial derivatives, which were created with this purpose in mind.

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Stock Hedging Explained

Hedging can, and does, take place in all financial markets. However, in this article, we are focusing solely on hedging in stock market. Before we look in detail at how to hedge stocks, let’s look at why someone would want to hedge stocks in the first place.

When we talk about hedging stocks, we are typically talking about a shareholder attempting to minimise the negative effect on their portfolio of a potential downturn in share price.

But hold on. If the shareholder is concerned about share price falling, why not just sell their shares?

Let’s say that an investor holds shares in Company A. The investor believes strongly in the long term growth of Company A and, therefore, wants to remain a shareholder for the long term. However, they have concerns about a possible short term fall in share price. The investor may choose to hedge their position in Company A in order to offset any potential losses incurred in the short term. 

Why not sell the shares before the price falls and buy them back at the lower price? Would that not be simpler?

The problem with this approach is that it does not take into account any capital gains tax or trading costs which might have to be paid. Furthermore, in reality, we do not actually know what is going to happen with the share price.

In our example, our investor is concerned about a short term fall in share price, but his concerns may not materialise. The price could remain the same or it could rise, adding to the potential losses already inflicted by capital gains tax.

Hedging Stocks with Financial Derivatives

The most common technique of stock hedging is undertaken using financial derivative products. A financial derivative is a security whose value depends on, or is derived from, an underlying asset, such as a company’s shares.

There are a wide variety of different derivative products available for traders, each come with their own characteristics, advantages and disadvantages. Here are a few of the most common:

• Options
• Futures
• Contracts For Difference (CFDs)

An investor wishing to hedge their long position in the stock market can do so by taking a short position in their chosen, relevant financial derivative; and vice versa. 

In the following section, we will take a practical look at hedging stocks by explaining how to hedge stocks using CFDs.

How to Hedge Stocks with CFDs

Contracts For Difference (CFDs) represent a contract between two parties agreeing to exchange the difference in the price of an asset between when the position is opened and when it is closed. 

CFDs allow traders to go both long and short on their desired market and also to benefit from the use of leverage, meaning that a trader need only put down a proportion of the position size, known as the margin, as an initial deposit.

As useful a tool as leverage is to a trader, it must always be used with caution. Whilst it has the potential to magnify a trader’s gains, it has equal potential to magnify their losses.

Stock hedging strategies using CFDs require an investor to take the opposite position on a stock CFD of the relevant stock, where one CFD is equivalent to one share.

Let’s say that an investor holds 100 shares in Apple, and is concerned about a fall in the short-term share price. In order to hedge this entire position, the investor could short sell 100 CFDs of Apple’s stock.

If Apple’s share price falls, the investor’s loss in share value would be offset by an equal gain in their short position on the Apple CFDs. On the other hand, if Apple’s share price rose, the investor’s equity position would benefit at the expense of their short CFD position.

Unlike stocks, there is theoretically no limit to the downside with CFDs. Therefore, traders should always use a stop loss when trading CFDs, which will automatically close a losing position once it crosses a predetermined threshold.

The Disadvantage of CFD Stock Hedging Strategies

Hedging stocks with CFDs is certainly not without its negatives. An investor must factor in the fees associated with trading CFDs when stock hedging. This sometimes includes commission charged by the broker and always includes what is known as the swap.

The swap is interest which is charged on a trader’s position if it is held overnight. This may not make much of an impact when the position is held for just a few days. However, it can soon start to add up if an investor is looking to hedge a position over a longer timeframe.

Final Thoughts

You should now be more familiar with the concept of hedging stocks and understand how to hedge stocks using CFDs.

In this article, we have looked at stock hedging in its simplest form, taking an opposing position in the same asset to mitigate risk.

However, it is also common also for investors to hedge against a specific risk. For example, a shareholder of BP who is concerned about a dip in oil prices negatively affecting their investment may choose to hedge their position by short selling oil as opposed to short selling BP shares. Alternatively, they may wish to protect themselves against general market risk by short selling the FTSE 100.

Hedging stocks can be an effective method of mitigating risk if done properly. Nevertheless, it should be used as part of a wider risk management strategy.

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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of, or recommendation for, any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.