Hedging
Diversification eliminates non-systematic risk. Rebalancing maintains target allocations. But neither can protect against broad market declines. Hedging fills that gap.
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 diversified away. It can only be hedged. If an exam question asks how to reduce market risk, the answer involves hedging instruments (puts, inverse ETFs), not adding more stocks.
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 | Generates income to cushion small declines | 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 |
| Inverse ETFs | Hold ETFs that move opposite to the market | Profits when market falls, offsetting portfolio losses | Loses value when market rises |
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
- 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
- Diversification eliminates non-systematic risk ONLY. It does NOT protect against market-wide downturns. To hedge systematic risk, investors must use options, inverse ETFs, or other hedging instruments.
- Know the three-part hierarchy: diversification for company risk, rebalancing for drift, hedging for market risk.