This is a first primer on hedging. This topic is way to big with to many facets to be done with in one post.
Hedging is often described simply as a way to reduce or eliminate risk. While that definition is broadly correct, it can be misleading because effective hedging is not about making an investment or portfolio “safe”. Rather, hedging is about managing specific unwanted exposures while preserving the risks that are responsible for generating returns.
This distinction is important. Every trade, strategy or portfolio is exposed to certain risks and some of those risks are intentional. A trader may be willing to accept certain risks because taking these risks is part of the strategy’s expected return. A hedge becomes useful when it removes an exposure that the trader does not want, without unnecessarily eliminating the source of the strategy’s potential return.
In other words, good hedging is not about removing risk completely. It is about deciding which risks you want to keep and which risks you want to manage/eliminate.
Two Types of Hedging
There are two broad reasons a trader might hedge: to isolate the source of a strategy’s edge or to protect against losses that could seriously damage the portfolio.
Hedging to Isolate Your Edge
The first type of hedging is designed to remove unwanted exposures. The objective is not necessarily to increase returns. Instead, it is to make sure you are only exposed to the risks that are necessary to capture the edge.
However, this type of hedging has to be used carefully. If the hedge removes too much exposure, it can also remove part of the return that the strategy was designed to capture. More on that later.
2. Hedging Against Catastrophic Loss
The second type of hedging is closer to buying insurance. Its purpose is to protect against an outcome that, while perhaps unlikely, could cause severe or irreversible financial damage.
A trader might use some forms of protection to reduce the impact of a major decline in a particular asset, strategy or in the broader market. The objective here is not to maximize returns. It is to make sure that a sufficiently bad outcome does not permanently impair the traders ability to continue trading.
This is the “don’t lose your house” form of hedging.
Insurance works this way in other parts of life as well. You may pay for homeowners insurance for years without making a claim, but that does not mean the insurance was useless. Its purpose is to protect you from a loss that would be extremely difficult to absorb. Financial hedging can work in much the same way.
Don’t Hedge Away Your Edge
For example, risk premia exist precisely because bearing these kind of risks is uncomfortable. If you could harvest a risk premium while eliminating the risk, it wouldn’t be a risk premium. You’re literally getting paid to take that risk.
This creates an important danger: you can hedge too much.
Suppose a strategy is designed to earn a return by accepting a particular type of market risk. If you systematically hedge that risk away, you may also eliminate the very exposure that generates the strategy’s expected return.
This is why hedging should begin with an understanding of the strategy’s economic engine. Before deciding what to hedge, a trader should identify where the edge or expected return is coming from.
A useful framework is to ask four questions:
What risk is generating my return?
Identify the exposure that the strategy is intentionally accepting.What risk am I trying to remove?
Distinguish between risks that are fundamental to the strategy and risks that are incidental or unwanted. The purpose of a hedge should be clear rather than simply “reduce volatility”.How much will the hedge cost?
You have to consider the obvious direct costs of the hedge ( i.e. transaction costs, financing costs, taxes) and the potential return given up by holding the hedge.Do I actually need the hedge to survive?
This is perhaps the most important question. A hedge may be unnecessary if the underlying risk is simply uncomfortable but financially manageable. Protection can be very valuable when an adverse outcome could permanently damage the portfolio.
Questions 1 and 2 are for type 1 hedging, 3 for both types and 4 mainly for type 2.
The Cost of Protection
Hedging is not free. Protection always comes at a price and that price can take several forms. Some costs are explicit and easy to see, while others are less obvious.
The most common costs of hedging include:
Option premiums
By buying options for protection, you pay an upfront premium. If the protected event never occurs, that premium is still gone.Trading and rolling expenses
Many hedges have to be renewed or adjusted over time. Frequent trading can generate commissions, spreads and other transaction costs.Reduced expected returns
A hedge can offset some of the gains from the underlying position. In effect, the trader is giving up part of the upside in exchange for a more limited downside.Margin requirements
Certain hedging strategies require capital to be posted as margin. Even when that capital is not directly lost, it may be unavailable for other opportunities.Taxes
Hedging transactions can create taxable gains or otherwise affect the tax efficiency of the strategy.
These costs are important because a hedge can appear attractive when viewed only in terms of the loss it prevents. The full economic calculation is more complicated. The investor must also consider what the protection costs during all the periods when the adverse event does not occur.
The Cost of Tail-Risk Protection
This becomes particularly important with tail-risk hedges, strategies designed to protect against rare but extremely severe events.
Tail-risk protection can be expensive precisely because the investor is paying for something that is expected to be useful only on rare occasion. If the hedge is structured correctly, the protection may repeatedly lose money and reduce portfolio returns. That can make the hedge feel like a drag on performance during ordinary times.
But that does not necessarily mean the hedge has failed.
The purpose of insurance is not to generate a profit every year. Homeowners do not expect their house to burn down so that their insurance policy can “pay off”. They pay the premium because the financial consequences of an uninsured catastrophe would be unacceptable.
Tail-risk hedging can be viewed in a similar way. The recurring cost is the price of remaining financially capable to stay in the game.
For this reason, the cost of certain hedges can be thought of as a form of survival expense rather than an investment that must independently generate a positive return!
But Protection Can Become Too Expensive
There is an important caveat: simply paying for protection indefinitely can itself become damaging.
If a trader continually buys expensive insurance, the cumulative cost can significantly reduce long-term wealth. A hedge that is theoretically protective may therefore be economically unattractive if its ongoing cost is too high relative to the risk being insured.
You are forced to smartly buy hedges, i.e. which option contracts. How to do that is out of the scope of this post.
Key Takeaways
Hedging is about managing risk, not making a portfolio completely safe
Separate useful risks from unwanted risks
Some risks are intentional and may be the source of a strategy’s expected return.There are two broad purposes for hedging
Isolating a strategy’s edge and protecting against a catastrophic loss.Catastrophic-loss hedging is like insurance
Its goal is to prevent a severe loss from permanently damaging your ability to keep trading.Every hedge has a cost
This may include premiums, trading and rolling expenses, margin, taxes, or reduced upside.
Conclusion
The purpose of hedging is not to eliminate uncertainty. In financial markets, uncertainty is unavoidable and attempting to remove it entirely will be both expensive and counterproductive. The real purpose of hedging is to decide which risks you are willing to accept and which risks you would rather minimize/eliminate.
Good hedging therefore begins with clarity about the problem you are trying to solve. Are you trying to isolate the source of your edge or are you trying to protect against a catastrophic loss? These are completely different objectives and therefore require different hedging strategies.
The central principle is simple:
Don’t hedge away your edge — and don’t lose your house.
A hedge is only useful when it addresses the targeted risk. Used without a clear purpose, however, it can turn a profitable strategy into an expensive endeavor.
Every hedge has a price, whether it appears as an explicit premium, a transaction cost, a financing expense, reduced upside, or simply opportunity costs. Protection that is purchased without a clear purpose can therefore become a persistent drag on performance.
This creates an important distinction between risk reduction and risk management. Reducing risk indiscriminately may sound attractive, but a strategy that removes every source of risk can also remove the very exposures responsible for generating its expected return.
The goal, therefore, is not to hedge everything that feels uncomfortable. Instead, the focus should be on risks that are unwanted or potentially catastrophic.
To wrap this post up, the essence of good hedging is not the elimination of risk, but the deliberate separation of useful risk from unwanted risk.
Disclaimer
The above article constitutes my or the authors’ personal views and is for entertainment purposes only. It is not to be construed as financial advice in any shape or form. Please do your own research and seek your own advice from a qualified financial advisor. I / The authors may from time to time hold positions in the aforementioned securities consistent with the views and opinions expressed in this article. The information provided in this article is not making promises, or guarantees regarding the accuracy of information supplied, nor that you guarantee for the completeness of the information here. The information in this article is opinion-based and that these opinions do not reflect the ideas, ideologies, or points of view of any organization the authors may be potentially affiliated with. The authors reserve the right to change the content of this blog or the above article. The performance represented is historical and that past performance is not a reliable indicator of future results and investors may not recover the full amount invested.