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This is a question from a layperson about the fundamental concept of hedging, with regards to investing, gambling, and any situation in which hedging is used to manage risk.

I do not understand why hedges are used as a risk management tool. Could the same reduction in risk not usually be achieved by simply betting/investing a smaller amount? I could imagine a situation where hedges would make sense - for example, where there is a minimum bet/investment that one is forced to make. But I get the impression that people use hedges all the time, even when there is the option of simply betting a smaller amount. Is it because risk in investing is measured as a percentage instead of a dollars-and-cents outcome? Or is it irrational, and related to the fact that hedging is simply more exciting than betting less?

In short: Why manage risk by hedging instead of managing risk by simply betting less?

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    Without getting into the complex details, here's an attractive (to me) multi-legged option hedge that I put with WYNN last fall. I bought the stock for $74 and per 100 shares I had the potential to make $3.90 in just less than 2 months (5.4% or 38% annualized). If WYNN dropped to $60 (and I did not make subsequent defensive adjustments), I would make $1.40 (downside break even of $58.60). Below $58.60 I would lose dollar for dollar just like any owner of the stock at any price. Hedging mitigates risk. – Bob Baerker Feb 15 at 16:33
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    Putting on a seatbelt is a hedge. You want the risk of driving to work to make money. You don't want the risk of getting killed in a car crash. So you hedge - you invest in the cost of a car to get you to work, but you add the cost of a seatbelt to "sell" some of the risk that piggybacked in on the deal. You could "bet" less by only working three days a week, of course - cutting your risk of being in a car crash by 40%, but also losing out on the 99.9% certainty that you would have otherwise made it to work fine and made some profit on those days you "bet less". – J... Feb 16 at 22:26
  • By definition the same reduction in risk cannot be achieved by simply betting/investing a smaller amount. If you bet/invest 10 or even 1 instead of 100 units, you can still reduce your risk through hedging. – Robbie Goodwin Feb 17 at 1:06

12 Answers 12

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Let's say I win a contract to supply widgets. The contract is for $600K.

Unfortunately I need 6 months to make the widgets but I've negotiated and I'll get paid $100K every month as I manufacture the widgets till I've supplied all I'm supposed to.

So far so good but I'm not located in the US and I need to pay my workforce in some other local currency. What happens if the dollar declines against that currency? I might not make any profit, worse I might not be able to pay the workers to continue making widgets.

So I hedge against the adverse currency movement. I contract to buy local currency for dollars upfront at an exchange rate defined today but at times in the future when I'll need the money. I'm now covered if the exchange rate moves against me. I can still pay people to make widgets and make the profit I wanted and as long as I continue to deliver widgets I'll get the money in dollars that I need to exchange.

Here I've eliminated currency exchange risk from my operation.

Airlines often do this with fuel which they need to pay for in dollars despite selling airline tickets some time earlier in local currencies.

In these cases there aren't any bets that you can bet less on.

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    I think this is beside the point because the question mentions 'betting' several times. OP clearly didn't have this scenario in mind, and it's not what most people think of when they talk about 'hedge funds' or similar. – Nobody Feb 14 at 15:32
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    The question text says any situation in which hedging is used to manage risk – Robert Longson Feb 14 at 16:43
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    When there is a contradiction in the question, and one possibility is mentioned independently many times in prominent places like the title and the 'In short' question, and the other possibility is supported by one plausible interpretation of a part of a sentence, then I go with the former possibility. – Nobody Feb 15 at 10:27
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    @Nobody: If it makes you feel better - a contract is a bet that you can deliver your side of the bargain while giving up less that's of value to you than you will gain from the other side. (Of course, the great thing is that it's a bet both sides can win.) Hedging here helps ensure you win your bet and make a profit. – psmears Feb 15 at 10:51
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    There are lots of great answers here which discuss how specific hedging strategies for a retail investor can leave you open to more gains while limiting your downside risk. However this answer is at its core the simplest example of why hedging itself can be desirable, even if it limits both upside and downside risk. In this example, you want to make profit from widgets. You don't want to profit from currency fluctuation, because that has risk to it. So you've taken the operational risk of owning a widget factory, and expect to profit from that, but declined the currency risk, by hedging. – Grade 'Eh' Bacon Feb 17 at 15:50
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There are many kinds of hedges and many different circumstances where one could employ them. Let's look at some random option scenarios for investing in Coca Cola (stock symbol KO):

  1. I buy 100 shares for $50.70 and I have the potential to make any amount that KO rises and lose any amount that KO drops.

  2. I buy 50 shares for $50.70 and I have the same risk/reward ratio (R/R) as #1. Buying fewer shares just linearly reduces the quantitative amount of the profit and loss (P&L).

  3. I buy 100 shares for $50.70 and I buy one Jan '22 $50 put for $4.80. In almost one year, make anything that KO rises above $55.50 I can lose no more than $5.50, no matter how far KO drops.

  4. I buy a 100 shares and add a $35p/$65c no cost option collar. I have the potential to make $15 (plus some/all of the dividends) with a maximum loss of $15.

  5. I buy the Jan '22 $52.50 call and sell one Jan '22 $62.50 call. This bullish vertical spread costs $2.35 and that is the most that can be lost in 11 months while having the potential to make $7.65.

  6. I buy the Jan '22 40 call for $11.20. That's a premium of only 50 cents over the cost of the shares but since share price is reduced by the amount of the dividend on the ex-dividend date, KO must rise 50 cents plus the amount of the dividend to break even. So for this one it's $11.20 of risk with open ended upside profit potential.

I'm not suggesting that the hedges are better or worse but what they do accomplish is that they alter the risk/reward, often quite favorably. Hedging mitigates risk.

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    The comparison of different possibilities is useful, but I expect this will mostly go over the head of a layperson. There probably aren't that many people who know what calls, puts, options, spreads, etc. are (to understand the answer) without also knowing why hedging is useful (to find the answer useful). Heck, I have a basic idea of what all those things are and I'm still struggling to follow this. – NotThatGuy Feb 14 at 21:52
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    @NotThatGuy - I crafted a 'what if' and provided 6 possibilities each with a brief explanation and a comparison of the P&L of each of the six examples is the basis for understanding why hedging may be useful. The eyes of the layperson might glaze over after reading some of this and he'll move on to the next answer ASAP. Someone who moderately understands options might have an AHA moment and decide that they want to investigate further. I can only answer within my ability to do so :->). If you really want you mind stretched, see if you can figure out the graphs in the other answer. – Bob Baerker Feb 14 at 22:38
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    Could you please ELI5 number 3? How does one single Put option cover the risk of 100 shares? – MPS Feb 15 at 1:04
  • Heh. I had to google ELI5 to understand what you want. A standard put gives the owner the right but not the obligation to sell 100 shares of the underlying stock at a set price (the strike price) within a specified time (the expiration date). – Bob Baerker Feb 15 at 1:11
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    100 shares costs $5,070. The put costs $480. That's a total cost of $5,550. The $50 put gives you the right to sell the stock for $5,000 so the maximum possible loss is $550. That's in dollars. A contract is quoted in points but since it's for 100 shares, you multiply that by 100 to get the total cost. – Bob Baerker Feb 15 at 9:23
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In its pure form, hedging is used to mitigate an existing risk that is inherent to some substantive (not just financial) activity. People work to provide for their families, so they often need life insurance. Firms produce and use physical commodities, so they often need futures contracts to protect from adverse price fluctuations. These activities have value in themselves and are not just "bets". Of course, hedging is only possible because there are also speculators to take the other side of the trade. The relation between hedging and speculation is further discussed here.

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  • The analogy with insurance is apt. You spend a few thousand to protect against the possibility of losing hundreds of thousands. – Barmar Feb 14 at 18:54
  • Hedging doesn’t always need speculators. For example, companies buying in dollars and selling in euro could be paired up with companies buying in euro and selling in dollars to enable both parties to hedge their currency risks with no speculation. – Mike Scott Feb 15 at 17:57
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    @MikeScott Without speculators, there would be a big lack of liquidity since the amount of hedging demand is unlikely to match simultaneously on both sides. – nanoman Feb 15 at 18:27
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In a nutshell, you typically would hedge only one direction of risk (the loss direction), leaving the gain direction open - you do want the gain.
Betting less would reduce both directions of risk - less to lose, but also less to gain.

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  • This is the most straightforward answer. The "bet" typically has an average expectation of a profit, so one does not want to bet less and withdraw from the activity, only to control the range of actual outcomes so that profit (of some quantity) is assured in any event. – Steve Feb 14 at 21:45
  • But futures are widely used for hedging (e.g., airlines locking in fuel prices or farmers locking in crop prices), and futures are symmetric between losses and gains. – nanoman Feb 14 at 23:08
  • @Steve: That's too simple - if the bet has an "average expectation of profit", then why are both parties interested in the agreement? An oil producer may hedge oil price risk in exactly the opposite direction of an airline, and there's no obvious reason that one party has the upper hand. – MSalters Feb 15 at 11:16
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    @MSalters, why should it concern the counterparty how the 'bettor' makes his money? (Bear in mind the bettor is the person engaged in some profitable-on-average economic activity). Neither the airline nor the oil producer expect to make money from hedging - they make money from flying passengers and delivering oil products. The hedge is only in place to redistribute funds between them, based on which direction the oil market swings - so if oil soars, the oil producer subsidises the airline, and if oil sinks, the airline subsidises the oil producer, ideally ensuring they both profit regardless. – Steve Feb 15 at 11:36
  • @MSalters usually the enterprise who is getting the edge as an insurance agains price fluctuations does not expect to come out ahead on average. The on-average loss is marked up as an affordable cost to prevent the risk of an unaffordable loss that might be an existential threath. – Rad80 Feb 16 at 10:00
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Anybody can bet a smaller amount. You can reduce your risk to zero if you bet nothing. But then you'll gain nothing.

As other posters have said, there are many forms of hedging. Sometimes they are used to reduce the risk of something going badly wrong when making a speculative investment.

Suppose you are about to short a stock. You think it's going to go down in price and you will make a tidy profit. But you have a nagging feeling that it might turn out to be the next GameStop and you'll be left shorting a stock that suddenly goes up.

You can hedge your risk by buying options on the same shares that you're about to short. If the shares do go down, you make money on the short position, and you discard the options. If the shares go up, you exercise the options, to buy the shares to rescue your position.

Taking out the options costs you a bit of money, but saves you from the risk of a catastrophic loss.

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  • Yeah, this type of hedge acts as a kind of insurance in that you pay a small amount no matter what (losing you that much potential profit), but in the case of catastrophe you are covered. – Kevin Feb 15 at 19:25
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    You can hedge your risk by buying options on the same shares that you're about to short. What you're describing is buying calls to hedge the upside risk of shorting the stock. This combination is equivalent to just buying puts. One transaction instead of two and it has less frictional costs and fewer commissions if you're still paying them. – Bob Baerker Feb 16 at 17:50
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No, reducing the amount you bet is not the same as hedging. If you think of contracts with uncertain payouts as lotteries, then hedges change the lottery you are playing.

Imagine you had two possible lotteries available to you. The first is to purchase 120 shares of ABC at 100 per share for $12,000 (or pounds or euros or whatever). The second is to purchase 100 shares of ABC and a 5 year put on ABC at a strike price of 100.

In both cases, you end up with $12,000 invested in ABC. However, for five years, you cannot lose more than $2000 if the price falls below $100 with the hedge.

The hedge changes the level of profit, but it also changes the slope of the profit line.

On the last day that the put contract would be active, the profit function of the two positions is shown by this graph.

put versus long

These are different lotteries. Because there are 120 long shares versus 100 hedged shares, the profit function in the out of the money area goes up by $1,200 per $10 improvement in price for the long position, versus $1,000 per $10 improvement in price for the hedged position. Hedging reduces return in exchange for capping losses.

The difference in the two positions can be seen in the next graph.

net differences

Hedging impacts your potential rate of return, noting that return is future value divided by present value. A better way to think about hedging is that a hedger is buying a different lottery than a person holding a pure long position.

If a person reduced their portfolio from 120 shares to 40 shares with the balance in a checking account, the profit function would be in the following graphic.

reduced versus hedge

The profit function chosen depends more on the preferences of the individual than anything else.

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  • At first glance, the divergence of the profit in graph #1 made no sense. Nor did the overall P&L at different share prices. Stumped! But then I realized that it's an uneven hedge (120 shares versus 100 shares with a put). The last graph was a clever way to display the performance advantage of the hedged position. Since you mentioned Euros, are 5 year contracts available in the EU? – Bob Baerker Feb 14 at 23:17
  • I don't know. I haven't ever considered it. It would probably trade on the Eurex Exchange, but I haven't looked into it. I made one edit to make it clearer. – Dave Harris Feb 16 at 1:55
  • The visually different profit curves should help people understand this a lot. – Yakk Feb 16 at 16:19
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Think of it like insurance.

Insurance is inherently a loss making proposition - if an insurance company paid out more than it took in, it wouldn't exist.

If you're a careful driver and own a car, you might never need insurance.

Plenty of people still get insurance, because the risk you're insuring against would be devastating, and the low probability makes it a cheap thing to insure against. (I mean, if you are a careful driver you will pay less for insurance!)

Hedging is broadly the same.

Imagine you own a house, and you are considering the 'house burns down' risk.

Now you could control that risk just by only investing half your wealth into a house. You have enough money in the bank to go get another one.

But in practice ... people don't. Why? Because the utility on a nicer house + Insurance works out better. The 'house burning down' risk is a low probability high impact event, that's relatively speaking going to cost less than 'the value of a house' to insure.

You lose out by doing this - I mean, assuming your house doesn't burn down, the money you spent on insuring it is wasted.

Hedging does the same thing - it lowers your expected returns for certain, because you're betting against yourself, but the risk probability asymmetry works in your favour - it costs less for more risk control.

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Another example of where hedging is used, particularly by hedge funds is to remove market impact and make bets on subjects where they have a knowledge advantage.

Let's say you do some analysis and find out that the Pfizer vaccine is significantly better than the Moderna vaccine (and nobody else has noticed it yet). You would like to invest in such a way that you can maximize the gain from this information.

You could just go long on Pfizer but then what if suddenly some countries decide to do a lot of extra tests before they permit to introduce any vaccine? You can hedge your self against this by going short on Moderna since Moderna would be equally impacted by this.

The money you gain from the Moderna stock going down makes up for the money you lose from the Pfizer stock going down. In this scenario you are now only making money if Pfizer performs better than Moderna (regardless of whether they both perform well or badly) which is what you have information on based on your analysis.

The risk of this investment is now dependent on how well your information can predict Pfizer performing better than Moderna and ideally your investment now has less risk for the same amount of return.

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  • Pairs trading is best suited for securities with a high historical correlation. The premise is that one hedges the other regardless of the trend (both rise or both decline). However, the pair has the potential to hurt you in opposition. In your long Pfizer, short Moderna example, suppose Moderna gets giant orders and Pfizer's vaccine is shunned? You lose on both positions. In this highly driven news situation, the correlation could easily break down and IMO, not a good hedge. Therefore I would disagree with Your investment now has less risk for the same amount of return. – Bob Baerker Feb 16 at 0:18
  • Yes if Moderna were to outperform Pfizer one would lose money. (Not necessarily on both positions since Pfizer might still do well). However in this example we do have information which would significantly increase the likelihood of Pfizer being the one to outperform Moderna. This hedge is the only way I see to bet on this outperformance specifically. The risk of this bet is now dependent on the quality of your information with respect to predicting this outperformance and might actually be higher as you pointed out so I will edit my response. – sev Feb 16 at 0:43
  • My point isn't about Moderna outperforming Pfizer. In that case the hedge works, just not profitably. In the case where your insider information is wrong and both stocks move in the wrong direction, you have double the losses with no hedge functionality. IOW, massive pair divergence in the wrong direction. – Bob Baerker Feb 16 at 20:37
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If you measure risk in a way that is independent of position size, then changing the position size does not affect the risk.

What if you measure risk in terms of a fraction of the amount invested?

What if you measure risk in terms of a fraction of the potential gain in particular scenarios?

What if you measure risk in terms of how much some index has to drop for the position to show any loss?

Measuring risk such that it is dependent on position size is atypical. For example, if someone says, "moderately risky portfolios had an average return of 8% while more conservative portfolios yielded less than 4%", they are clearly measuring risk in a manner that is independent of absolute position size.

Hedging reduces risk independent of absolute position size.

For example, consider buying a stock. The typical outcomes are that the stock goes up a bit or goes down a bit. But it could rocket to the moon as Gamestop did or it could crash to zero as Enron did. Hedging might mean trading off some of the possible enormous gains that are unlikely to materialize to avoid some of the enormous losses that are also unlikely to materialize. This makes holding the stock less risky, regardless of how much you hold.

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In a pure gambling sense, I've seen this approach used where there are additional benefits offered aside from the individual win.

For example, many bookmakers provide a "free bet" if you bet a certain amount on an event or in a time period. People may bet both ways and take a small loss/break even purely in order to receive the free bet.

Again in a betting context, this approach can be used over time, especially with horses/dogs where the odds are highly volatile and time sensitive. You may bet one way and monitor the price "against" your bet to find the lowest amount of stake needed to make a profit, or hope it goes so far that you can bet the same amount in the other direction and make a guaranteed profit, I think this is know as "arbing".

Disclaimer, I'm pretty sure despite being "legal" that bookmakers will ban you doing this. Presumably because it can encourage price manipulation on large scales.

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Investing less would decrease ROI while maintaining the same proportional risk. This would provide no hedge benefit. Many associate the word 'hedge' with a pure expense one might pay to decrease portfolio volatility or margin requirements. But in reality the 'hedge' is just another piece of your investment that can be as or more profitable than the position 'hedged'. As a trading example, we use delta-hedged strangles to generate income. This usually involves selling a call and put (above and below) the market. If one matches 'deltas', the trade is automatically 'hedged' when it is placed with both sides equally likely to be profitable. As markets change (volatility, stock moves, etc) increasing or decreasing the number of short calls/puts allows one to continually neutralize (hedge) deltas. If the underlying becomes very volatile one may need to take a short/long position in the underly stock/future, etc to maintain delta neutrality. One might further hedge risk by purchasing an 'out of the money' call/put to decrease both volatility and buying power reduction, which in an of itself increases ROI. This is just one example of an infinite number of cases in which hedging is used to decrease overall risk and increase ROI. But do keep in mind that any part of the entire trade/investment could function as a 'hedge' to all the other elements. For example, if your wife buys a life insurance policy on you and you don't die, your continued productivity can serve as a hedge on the premium she lost in her investment.

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Hedging is a pretty complex topic, and requires in depth knowledge to do it well. It requires certain circumstances to be present in order for a hedge to make more sense than, as you say, "betting less." In the right situation a hedge can reduce the risk if your "bet" is wrong without (significantly) reducing the payout if it is right. You can't just place a bet on black on the roulette wheel to offset your bet on red. That's not a hedge, that's a dumb bet.

They key distinction is that if you limit your risk by only investing or betting half as much, then you've also reduced your potential benefit by half. A proper hedge could limit your downside in a similar manner without the same reduction on the upside. Several other answers give some examples of ways to do this, although they are pretty technical. It's hard to give a lay-person example of how it works in practice, precisely because the cases where it is beneficial are complicated. If it was easy, we'd all be able to get rich doing it, and casinos and fund managers would all go broke...

Another thing to keep in mind is that a poorly done 'hedge' can increase your risk in unexpected circumstances. To go back to my roulette example, based on the odds, one might naively assume that placing countering bets on red and black would always cause you to break even. Until the wheel rolls a '0', and you lose both your bets. While this is - as I said - a dumb bet, there are essentially similar strategies sometimes used in investing that rely on limiting risk by buying different assets that are expected to counter a drop in the primary investment. These strategies run the risk of failing spectacularly if the market does something unexpected, and you discover that your 'hedge' wasn't actually a hedge, just a poor investment.

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  • A proper hedge could limit your downside It's a sensible answer except for the last paragraph where I believe that your conclusions are reversed. If you hedge the downside with say OTM puts (the OTM amount is the deductible), you could lose the deductible and the premium paid if the underlying only drops to the put's strike. Here, the hedge added to the loss. If things go downhill in a really unexpected way and the stock market drops over 30% in a month, you get the full benefit of the hedge below the strike price. I was there last March when my equity loss was 7-8% due to SPY puts. – Bob Baerker Feb 16 at 20:33
  • There are different ways to hedge - some strategies involve using different securities that under normal market conditions would be expected to move in the opposite direction as your main investment. That kind of strategy can break down when the market doesn't behave normally. That is more akin to my example of placing opposing bets on red and black than e.g. using an option PUT, so you could argue that it's not a 'proper' hedge, but I was trying to reiterate that hedging is complicated, and could make things worse if you don't understand what you're doing. I'll try to reword that part. – Drew Feb 17 at 16:30

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