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Hedging Part 2

For the most part hedging techniques involve using complicated financial instruments known as derivatives.  The two most common derivatives are options and futures. We will not get into describing how these instruments work (see Options 101 in the Topic section for more information). For now just keep in mind that with these instruments you can develop trading strategies where a loss in one investment is offset by a gain in a derivative. 

Let's see how this works with an example. 
Say you own shares of ISRG before earnings.  Although you believe in the long term aspects of the company the chart may look negative in the short term and at one point it rolls over into a down trend.  At that point you hate the chart with a long position in the stock but you still love the company.  You are worried about a short term loss but do not want to sell your shares.  What can you do The answer is you can protect yourself from a fall in the stock price by buying a put option (a derivative) on the stock which gives you the right to sell ISRG at a specific price (strike price). This strategy is known as a married put. If your stock price tumbles below the strike price these losses will be offset by gains in the put option. 

The other classic hedging example involves a company that depends on a certain commodity. Let's say SBUX is worried about the volatility in the price of coffee. The company could be in trouble if the price of coffee were to skyrocket which would eat into profit margins severely. To protect (hedge) against the uncertainty of coffee prices SBUX can buy a futures contract that allows the company to buy the coffee at a set price. Now SBUX can budget without worrying about the fluctuating commodity price. If the coffee skyrockets above that price specified by the futures contract the hedge will have paid off because SBUX will save money by paying the lower price. 

Keep in mind that because there are so many different types of options and futures contracts an investor can hedge against nearly anything whether a stock commodity price interest rate or currency. 

The Downside
Every hedge has a cost so before you decide to use hedging you must ask yourself if the benefits received from it justify the expense. Remember the goal of hedging is not to make money but to protect you from losses. The cost of the hedge whether it is the cost of an option or lost profits from being on the wrong side of a futures contract cannot be avoided. This is the price you have to pay to avoid uncertainty. 

We have been comparing hedging versus insurance but we should emphasize that insurance is far more precise than hedging. With insurance you are completely compensated for your loss (minus a deductible). Hedging a portfolio is not a perfect science and things can go wrong. Although risk managers are always trying for the perfect hedge it is difficult to achieve in practice. 

The Upside
The majority of investors will never trade a derivative contract in their life. In fact most investors who buy and hold ignore shortterm fluctuations in the market altogether. 

Even if you never hedge for your own portfolio you should understand how it works because many big companies and investment funds will hedge in some form. You should try and gain a fairly good awareness of how investors and companies work to protect themselves with hedging. Whether or not you decide to start trading derivatives learning about how hedging works will help advance your understanding of the market.







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