Advantages & Disadvantages of Hedging

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Nobody likes to lose money, but that's always a risk when you invest it. One solution is to hedge your bets. If you're worried a long-term stock investment might tank, for instance, you can buy a put option which entitles you to sell at a pre-set price. If the stock stays strong, you keep it; if the price drops, you sell and cover some of your losses. Like most financial strategies, hedging your investments has both benefits and drawbacks.

Reward Versus Safety

Risky gambles attract investors because when they pay off, it can be big. Hedging your bets reduces your risk, but it usually reduces your potential gain, too. Investors in crude oil, for example, sometimes hedge by investing in airline stocks. Airlines need lots of fuel, so stock prices historically rise and fall in opposition to crude oil prices. If you invest in both and the oil price drops, your airline stocks will rise and mitigate the damage to your portfolio.

The catch? If oil prices go up, your airline investment goes down. You've limited how much you can lose, but hedging your bets limits how much your portfolio's net worth can grow, too. Most strategies that hedge against the stock market falling reduces your gains in a bull market.

Things Get Complicated

A put or call option to sell or buy a stock is a classic hedge. An option to buy saves you money if the stock becomes a hit, but you let the option expire if the stock underperforms. If you own just one or two stocks, this may be an excellent strategy.

If you already have a diversified portfolio, this strategy ranges from difficult to impossible. Trying to arrange options for many different stocks or multiple asset classes takes a tremendous amount of time and analysis. Paying to take out options on every item in the portfolio may also be cost-prohibitive. Even a simple strategy such as liquidating some of your stocks has its negative side: you have to decide the right time to leave the market and when to return.

What's Your Time Frame?

Hedging makes the most sense if you're investing for the short-term. Suppose you plan to sell your fastest-rising stocks in three-to-six months. If the market tanks when you need to sell, that's going to cost you. Smart hedging can lessen the shock.

If you're holding for the long-term, you should be ready to ride out any temporary dips in the market. Simply balancing your portfolio with a mix of bonds alongside the stocks may be enough of a hedge for your needs.

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About the Author

Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com