Quick Answer
Hedging means using financial instruments to offset potential losses in an existing investment position. Protective puts and index puts can limit downside exposure; their premiums reduce returns. A covered call provides only a limited cushion from the premium received and caps upside potential.
Diversification reduces company-specific risk, but adding more stocks does not eliminate a portfolio's exposure to a broad stock-market decline. Hedging can offset that exposure. Asset allocation can also reduce exposure by shifting part of a portfolio away from stocks.
What Is Hedging?
- Hedging is using financial instruments to offset potential losses in an existing position
- Unlike diversification, hedging CAN reduce systematic (market) risk
- The tradeoff: hedging reduces risk but also limits potential return (the cost of the hedge eats into gains)
Exam Tip: Gotchas
- Systematic risk CANNOT be eliminated by adding more stocks. Index puts can hedge a portfolio's exposure to a broad market decline. Holding more individual stocks addresses company-specific risk instead.
Common Hedging Tools
| Strategy | How It Works | Risk Reduced | Tradeoff |
|---|---|---|---|
| Protective put | Buy a put option on a stock you own | Limits downside loss | Premium cost reduces returns |
| Covered call | Sell a call option on a stock you own | Minor downside losses (limited to the premium received) | Caps upside if stock rises above strike price |
| Index options | Buy puts on a market index (S&P 500) | Hedges systematic/market risk of a diversified portfolio | Premium cost |
Protective Put in Detail
- You own 100 shares of stock at $50/share
- You buy a put option with a $45 strike price
- If the stock falls below $45, the put gains value, limiting your loss
- Your maximum loss = stock price minus put strike price, plus the premium paid
- The gap between the current stock price and the strike price is the unprotected zone: the put provides no intrinsic value until the stock falls below the strike. The premium is a separate, additional loss you bear regardless of where the stock goes.
- Your upside remains unlimited (minus the premium cost)
Think of it this way: A protective put is like buying insurance on your car. You pay a premium, and if something bad happens (the stock drops), you are covered below a certain amount. If nothing goes wrong, you only lose the premium you paid.
Exam Tip: Gotchas
- A protective put = buying a put. The word "protective" tells you this is a long (purchased) put. The investor pays a premium upfront.
- Maximum loss is defined, but upside is unlimited. This is the opposite of a covered call.
Covered Call in Detail
- You own 100 shares of stock at $50/share
- You sell a call option with a $55 strike price, collecting a premium
- If the stock stays below $55, you keep the premium as income
- If the stock rises above $55, you must sell at $55 (capping your upside)
- The premium provides a small buffer against downside moves
Exam Tip: Gotchas
- A covered call caps your upside. You collect premium income, but if the stock soars past the strike price, you miss out on those gains.
- Covered calls are NOT true downside protection. The premium only cushions small declines. For real downside protection, use a protective put.
Risk Mitigation Summary
| Strategy | Mitigates | Does NOT Mitigate |
|---|---|---|
| Diversification | Non-systematic risk | Systematic (market) risk |
| Rebalancing | Allocation drift, concentrated risk | Does not add new risk reduction |
| Hedging | Systematic and non-systematic risk | Cannot eliminate the cost of hedging (premium) from returns |
Exam Tip: Gotchas
- Stock diversification addresses non-systematic risk. It does not eliminate exposure to market-wide downturns. Index puts can hedge that market exposure.
- The risk hierarchy has three parts. Diversification for company risk, rebalancing for drift, hedging for market risk.
What Should You Check on Exam Day?
- Can you explain why hedging, not diversification, is the tool that reduces systematic risk?
- Do you know the difference between a protective put and a covered call?
- Can you state why a covered call caps upside while a protective put keeps upside unlimited?
- Do you know how index put options can hedge systematic risk?