Individual investors usually hedge for two reasons:
Over-concentration: You own a lot of stock in one company, so you want to protect yourself.Tax implications: You can use hedges to delay the sale of a stock or other asset while protecting its value.
Example of Hedging
Suppose the 100 shares of Apple stock you recently purchased have done very well and are sitting at $175. You’d like to hold on to the shares, but you’re concerned that the price will go down if you hold them too much longer. To hedge, you buy a put option for your shares with a strike price of $160. You pay a premium to retain the right to sell your shares at that price. Two weeks later, Apple has a bad earnings report and the stock price plummets. It hits $160 and you exercise your option to stop the bleeding. If the price of the stock had stayed the same or gone up, you would have let the option expire and lost whatever you paid for premiums. If you wanted to continue the strategy, you would have to purchase a new put option.
Types of Hedging Strategies
Typically, investors create hedges using various types of derivatives such as options, futures, and forwards. Inverse ETFs may also be options for hedging in certain cases, but are risky investments.
Protective Puts
Puts give you the right to sell your stock at a specified price for a specified time. You choose the price at which the put sells (strike price), providing you with a secure floor for your stock’s price. Protective puts can limit or eliminate losses. However, they aren’t free; you have to pay a premium for them, so you could lose money if your stock never drops enough to hit the strike price.
Covered Calls
Calls give you the right to buy a stock at a specified price for a specified time. If you wanted to hedge your Apple shares, you could sell covered calls. The calls would generate income in the form of premiums the buyer pays you as long as the stock doesn’t hit its strike price. So, if the stock price drops like you’re worried it will, you’ll earn premiums from the covered call. However, if the stock’s price hits the strike price, then your gains are capped at the strike price.
Collars
Collars are a combination of protective puts and covered calls. You buy the puts to protect against a drop in stock price and, in theory, your calls generate premiums you can use to pay for your puts.
What It Means for Individual Investors
Hedges can be expensive in some cases, and price fluctuations are expected over time. Because of that, they aren’t recommended for investors who just want to buy and hold a stock. If you choose to create a hedge, be sure you understand the mechanics of the hedge, including (when applicable) the strike price and how much you’ll pay or earn in premiums.
