WHAT IS
HEDGING

Buying or selling one asset can offset risk associated with other positions, or your entire portfolio. Done correctly, hedging can act as an insurance policy and smooth out returns. This guide will explore what hedging is and how you can get started.

---

Hedging is a risk management strategy where investors take offsetting positions to reduce potential losses from adverse price movements in their existing investments. Think of it as financial insurance: while you pay a premium (the cost of the hedge), you protect yourself against significant downside risk. 

Unlike diversification, which spreads risk across multiple assets, hedging specifically targets and offsets the risk of individual positions or concentrated exposures.

What Is Hedging in Financial Markets?

Hedging in the financial markets involves opening positions in assets which you think will experience price moves which are contrary to those you already hold in your portfolio. If your primary investments fall in value, your hedge might increase in value, off-setting some of the overall loss.

When investors hedge, they accept a known cost (the hedge premium or spread) in exchange for protection against larger potential losses. This strategy is particularly common among institutional investors and traders managing concentrated positions. 

The goal of hedging isn’t to eliminate all risk, which is impossible. Instead hedging is used to transform unpredictable losses into more manageable, quantifiable costs.

Volatilityplays a crucial role in hedging decisions. Higher volatility typically increases both the need for hedging and its cost. 

How Does Hedging Work?

Hedging works by creating an offsetting position that gains value when your primary investment loses value, thereby reducing net exposure to price movements. The effectiveness depends on the correlation between the hedge and the underlying asset.

The mechanical process of hedging follows a systematic approach:

1. Identify exposure – Determine which specific risks need protection (price risk, currency risk, interest rate risk) 

2. Choose offset relationship – Select instruments with inverse or negative correlation to your exposure 

3. Select instrument type – Decide between options, futures, CFDs, or other derivatives based on your needs 

4. Recognise costs and limitations – Account for premiums, spreads, and the imperfect nature of most hedges

For example, if you own £10,000 worth of UK equities and fear a market downturn, you might purchase put optionson the FTSE 100 Index (UK 100). If the market falls 10%, your equity portfolio might lose £1,000, but if your put options gain £800 in value, you limit your net loss to £200 plus the option premium.

Advantages and Disadvantages of Hedging

Hedging offers potential protection against adverse price movements and can provide portfolio stability, but comes with significant costs and complexity that can erode returns. Understanding these trade-offs is essential for effective risk management.

Advantages: 

• Downside protection: Limits potential losses during market declines or adverse price movements 
• Portfolio stability: Reduces overall portfolio volatility and provides more predictable returns 
• Flexibility: Allows maintaining core positions while managing short-term risks 
• Peace of mind: Reduces emotional stress during volatile market conditions

Disadvantages: 

• Cost drag: Premiums, spreads, and transaction costs reduce overall returns 
• Limited upside: Protection comes at the expense of potential gains if markets move favourably 
• Imperfect hedges: Basis risk means hedges rarely provide complete protection 
• Complexity: Requires ongoing monitoring, adjustment, and sophisticated understanding of derivatives 
• Correlation risk: Relationships between assets can break down during extreme market events

Common Hedging Strategies

Traders can employ various hedging strategies depending on their risk exposure and market outlook, with direct hedging, pairs trading, and safe haven allocation being the most prevalent approaches. Each strategy has distinct mechanics and applications.

Understanding these strategies helps investors select appropriate hedging techniques for their specific circumstances. The choice depends on factors including the type of exposure, available instruments, cost considerations, and the investor’s sophistication level.

Direct hedging

Direct hedging involves taking an opposite position in the same or highly correlated asset to offset potential losses, typically using derivatives like options or CFDs. This strategy typically provides the most direct form of protection but can be expensive.

Illustrative example – Direct Hedging:

• An investor owns 1,000 shares of a major UK bank trading at £5 per share 
• Exposure = £5,000
• The position is vulnerable to banking sector volatility 

• Hedge concept: Purchase put options in the bank they hold shares in with a £4.50 strike price 
• Possible outcome: If the price of the banking shares fall to £4, the £1,000 loss is partially offset by £500 gain on puts 
• Limitations: Option premium costs reduce net returns and the protection only applies below the £4.50 price level.

Derivativesare the primary tools for direct hedging. The key is selecting appropriate strike prices and expiration dates that balance protection with cost.

Pairs hedging

Pairs hedging involves simultaneously holding long and short positions in two correlated assets. The net profit/loss being determined by their relative performance rather than absolute price movements. This market-neutral approach reduces directional risk.

Illustrative example – Pairs Hedging:

• A trader identifies two large UK retailers with similar business models.
• Exposure = The trader builds a stock position of £2,000 in the stronger company.
• The position would be exposed to systematic risk and sector risk – the risk that the broader market or UK retail sector may experience a correction.

• Hedge concept: Long position in the stock of the stronger company is balanced by a short position in the weaker one.
• Possible outcome: If retail sector or wider stock market declines 10%, any gains in the short position would net off against losses in the long position
• Limitations: The correlation between the two stocks may be weak. If there is no correction and both stocks rise in price the short position will record a loss.

This strategy requires careful analysis of historical correlations and fundamental differences between the paired assets. Market-neutral positioning is the goal, but achieving true neutrality is challenging.

Safe haven hedging

Safe haven hedging involves allocating capital to assets that historically maintain or increase value during market stress, such as gold, government bonds, or defensive currencies. These assets typically have negative correlation with risk assets during crises.

Illustrative example – Safe Haven Hedging: 

• A portfolio manager concerned about geopolitical tensions affecting equity markets 
• Exposure = £100,000 equity portfolio vulnerable to risk-off sentiment 

• Hedge concept: Allocate £10,000 to gold ETFs and UK gilts 
• Possible outcome: During market stress, equities fall 15% but gold rises 8%, partially offsetting losses. 
• Limitations: Safe havens can underperform during risk-on periods, creating opportunity cost. Safe haven correlations aren’t guaranteed and can change based on the specific nature of market stress.

Short Hedge vs Long Hedge

Short and long hedges serve opposite purposes: short hedges protect against falling prices of assets you own or plan to sell, while long hedges guard against rising prices of assets you need to purchase. Understanding when to apply each is crucial for effective risk management.

The choice between short and long hedging depends on your existing exposure and future obligations. Producers typically use short hedges to lock in selling prices, while consumers use long hedges to secure buying prices.

Short hedge explained

A short hedge is a technique employed by investors and traders to protect themselves from the risk of an asset they hold declining in value in the future. It involves opening a short position and is typically used when an investor already expects to sell the asset rather than keep it as part of their portfolio in the long term.

Illustrative example – Short Hedge: 

• An U.S. wheat farmer expects to harvest 1,000 tonnes of wheat in three months. 
• Exposure = The harvest is valued at $50,000 at current market prices. 
• Risk = Wheat prices fall before harvest.

• Hedge concept: Sell wheat futures contracts for delivery in three months. 
• Possible outcomes: If spot prices fall 20%, futures position gains offset the lower selling price. 
• Limitations: If prices rise, the farmer misses out on additional profits.

Short hedging is particularly common among commodity producers, equity investors during uncertain periods, and fixed-income holders worried about rising interest rates. 

The strategy essentially locks in current price levels, sacrificing potential upside for downside protection.

Long hedge explained

A long hedge protects against rising prices of assets you plan to purchase in the future, using long positions in futures or options to lock in current prices. This strategy is essential for businesses wanting to achieve predictable input costs.

Illustrative example: Long Hedge: 

• An UK manufacturer requires 100 tonnes of copper in six months. 
• Exposure = Risk that copper prices increase before purchase. 

• Hedge concept: Buy copper futures contracts for six-month delivery. 
• Possible outcome: If copper rises 15%, futures gains offset higher purchase costs.
• Limitations: If prices fall, the manufacturer pays above market rates due to futures losses.

Long hedges are commonly used by airlines hedging fuel costs, manufacturers securing raw materials, and importers managing currency exposure. The trade-off is between price certainty and the flexibility to benefit from favourable price movements.

Instruments Commonly Used for Hedging

Various financial instruments serve hedging purposes, each with unique characteristics, costs, and risk profiles that make them suitable for different hedging scenarios. 

Selecting the appropriate instrument is crucial for effective risk management with some popular hedging tools outlined in the table below.

Instrument	Risk Reduced	Typical Context	Key Limitation/Risk
Options	Directional price risk	Protecting equity portfolios	Option premiumcosts can be substantial
Futures	Price uncertainty	Commodity and currency hedging	Marginrequirements and potential losses
CFDs	Short-term price movements	Intraday hedging	Leverageamplifies both gains and losses
Inverse ETFs	Market downturns	Broad market protection	Daily rebalancing causes tracking errors over time
Currency forwards	Foreign exchange risk	International trade	Locked-in rates prevent benefiting from favourable moves

Each instrument requires different levels of sophistication and capital commitment. Options provide the most flexibility but can be expensive, while futures offer precise hedging but require margin maintenance. CFDs suit short-term tactical hedging, while inverse ETFs provide accessible market hedging for retail investors.

Final thoughts

Hedging does not attempt to eliminate risks to your portfolio, rather it aims to transform unpredictable losses into quantifiable costs. 

Engaging in hedging requires careful consideration of the trade-offs between protection and profitability and understanding how to select appropriate instruments for your purposes while maintaining realistic expectations.

Effective hedging requires overcoming particular challenges such as timing implementation, managing costs, monitoring effectiveness, and adjusting positions as market conditions change. Despite the workload, and the fact that hedging is rarely perfect, it is something to consider especially if you have concentrated exposure to particular risk factors.

Visit the eToro Academy to learn more portfolio management techniques.

Quiz

FAQs

Does hedging eliminate all investment risk?

No, hedging cannot eliminate all risk. It reduces specific, targeted risks but cannot protect against systematic market risk, and imperfect correlations mean some residual risk always remains.

Why can hedging reduce returns even in favourable markets?

Hedging involves costs such as option premiums, futures margins, and spreads that reduce profits. Additionally, hedging positions often lose value when primary investments gain, creating a drag on overall returns.

What is correlation risk in hedging?

Correlation risk occurs when the historical relationship between a hedge and the underlying asset breaks down, causing the hedge to move independently rather than providing the expected offset. This risk intensifies during market stress.

What is an inverse ETF?

An inverse ETF is an exchange-traded fund designed to profit from a decline in the value of an underlying benchmark. These funds use derivatives to achieve -1x or -2x the daily performance of their target index.

What are the common costs associated with hedging?

Hedging costs include option premiums, bid-ask spreads, margin interest on futures positions, management fees for inverse ETFs, and opportunity costs from limiting upside potential. Transaction costs and potential tax implications add to the total expense.