Large companies use hedging strategies to protect themselves against price changes in raw materials that could hurt profits. Individual investors may want to hedge some investment positions to avoid a hit on investment values if a bear market or even a crash occurs. The derivative financial products of futures and options provide different ways to hedge your investments against losses.
A hedge is a securities position that will earn an offsetting gain if your regular investments, typically stocks or stock funds, suffer a serious loss in value. A hedge needs to employ leverage so it does not cost you a lot of money to hedge some or all of your investments. Hedges will also be derivative securities that increase in value when the underlying asset -- what the derivative is derived from -- drops in value.
Hedging with Options
Options are limited term contracts that allow you to buy or sell an underlying security for a fixed price until a specified expiration date. Of the two types of options -- calls and puts -- puts are typically used to hedge stock market values. Puts trade against individual stocks, exchange-traded funds and stock indexes. Put options go up in value when the underlying asset declines below the exercise price of the option. Options trading authorization can be added to any stock brokerage account, allowing you to quickly hedge against an expected drop in the stock market or specific stock prices.
Options Pros and Cons
Put options can provide a significant level of leveraged hedge protection at a relatively low cost. The very large numbers of available options allow you to tailor your put option hedge to cover specific stocks or sectors of the stock market and control the leverage vs. cost ratio of you hedging. The major downside to using options is the expiration date. Long-term options can be expensive, and a short-term option may result in the options expiring before you really need the hedge protection. The large number of available options can also be viewed as a negative. You may correctly forecast a market drop and have picked the wrong options to hedge the size of the decline.
Hedging with Futures
Futures contracts trade on the commodity futures exchanges and you need an account with a commodity futures broker to use futures for trading or hedging purposes. Futures contracts cover the most popular market stock indexes plus the major stock sector indexes. To hedge against a falling market you would sell or go short the stock index futures contract that best matches the make up of your stock portfolio. To trade futures you must put up a margin deposit worth 5 to 10 percent of the futures contract value.
Futures Pros and Cons
Relative to the amount of a stock portfolio one future contract can hedge, the cost of using futures is basically zero. Once you have sold short futures contracts, the contracts will change value in direct opposite proportion to the underlying stock index. Longer-dated futures contracts can be used to hedge or short-term futures can be rolled forward at little or no additional cost. The biggest negative of futures as hedges is the direct correlation of values. If the value of hedged stocks go up by $50,000, the futures will drop by a nearly equal amount. Hedging with futures will offset with losses any stock market gains as long as you carry the hedge.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.