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 the instability of the markets.
The traditional approach is to offset losses in one investment by purchasing a second investment that is expected to perform in an opposite way. Short selling and buying put options are two examples of hedging techniques.
When you sell short, you borrow shares of stock you believe will fall in price and then sell them. If the price falls, you repurchase the shares at a lower price in the secondary market, realizing a profit. This strategy alone can be quite risky, as the stock's price is not guaranteed to fall. However, it can also 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 will 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. You also need to consider the transaction costs 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, 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 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.
However, 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.
Options at Scottrade
Options involve risk and are not suitable for all investors. Detailed information on our policies and the risks associated with options can be found in Scottrade's Options Application and Agreement, Brokerage Account Agreement, and Characteristics and Risks of Standardized Options (available at your local Scottrade branch office or from the Options Clearing Corporation at 1-888-OPTIONS or by visiting www.888options.com). All option accounts require prior approval by Scottrade. Market volatility, volume, and system availability may impact account access and trade execution. Supporting documentation for any claims will be supplied upon request.
Margin trading involves interest charges and risks, including the potential to lose more than deposited or the need to deposit additional collateral in a falling market. Scottrade's margin agreement, available at scottrade.com or through a Scottrade branch office, contains the Margin Disclosure Statement and information on our lending policies, interest charges and the risks associated with margin accounts.