There are several effective hedging strategies to reduce market risk, depending on the asset or portfolio of assets being hedged. Three popular ones are portfolio construction, options, and volatility indicators.
Key Takeaways
- Market risk, or systematic risk, is the possibility that an investor will see huge losses as a result of factors that impact the overall financial markets, as opposed to just one specific security.
- Modern Portfolio Theory is one of the tools for reducing market risk, in that it allows investors to use diversification strategies to limit volatility.
- Another hedging strategy is the use of options, which allow investors to protect against the risk of big losses.
- Investors can also make trades based on market volatility by tracking the volatility index indicator, the VIX, often referred to as the "fear index," due to its tendency to spike during periods of greater volatility.
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Modern Portfolio Theory
One of the main tools is themodern portfolio theory (MPT), which uses diversification to create groups of assets that reduce volatility. MPT uses statistical measures to determine an efficient frontier for an expected amount of return for a defined amount of risk. The theory examines the correlation between different assets, as well as the volatility of assets, to create an optimal portfolio.
Many financial institutions have used MPT in their risk management practices. The efficient frontier is a curved linear relationship between risk and return. Investors will have different risk tolerances, and MPT can assist in choosing a portfolio for that particular investor.
$16.6 billion
The daily trading volume of all options contracts in the U.S. market, as of May 10, 2024.
Options
Options are another powerful tool. Investors seeking to hedge an individual stock with reasonable liquidity can often buy put options to protect against the risk of a downside move. Puts gain value as the price of the underlying security goes down.
The main drawback of this approach is the premium amount to purchase the put options. Bought options are subject to time decayand lose value as they move toward expiration. Vertical put spreads can reduce the premium amounts spent, but they limit the amount of protection. This strategy only protects an individual stock, and investors with diversified holdings cannot afford to hedge each position.
Investors who want to hedge a larger, diversified portfolio of stocks can use index options. Index options track larger stock market indexes, such as the and Nasdaq. These broad-based indexes cover many sectors and are good measures of the overall economy.Stocks have a tendency to be correlated; they generally move in the same direction, especially during times of higher volatility.
Investors can hedge with put options on the indexes to minimize their risk. Bear put spreads are a possible strategy to minimize risk. Although this protection still costs the investor money, index put options protect a larger number of sectors and companies.
Volatility Index Indicator
Investors can also hedge using the volatility index (VIX) indicator. The VIX measures the implied volatility of at-the-money calls and puts on the S&P 500 index. It is often called the fear gauge, as the VIX rises during periods of increased volatility. Generally, a level below 20 indicates low volatility, while a level of 30 is very volatile. There are exchange-traded funds (ETFs) that track the VIX. Investors can use ETF shares or options to go long on the VIX as a volatility-specific hedge.
Of course, while these tools are certainly powerful, they cannot reduce all market risk.
What Does Hedging Mean in Finance?
Hedging is a financial term for investments that pay off if the principal investment thesis is incorrect, thereby limiting the investor's exposure to risk and expected losses. An effective hedging strategy may reduce the investor's maximum possible payoffs, but also reduces their maximum losses.
How Are Hedge Funds Different From Other Investors?
A hedge fund is a private investment fund run by professional portfolio managers. Because it is only available to wealthy investors, a hedge fund can take advantage of alternative investments and strategies that provide higher-than-market returns.
What Hedging Strategies Are Available to Retail Investors?
While sophisticated hedging strategies may not be practical for everyone, there are ways for a retail investor to reduce their risk exposure. A simple example is the three-fund portfolio with exposure to domestic equities, international equities, and domestic fixed-income instruments. Since it is unlikely that a market downturn will affect all three asset classes equally, this type of portfolio helps to ensure at least some of your investments will remain stable. In addition, some investors may also pursue a more active management strategy by identifying specific companies that are most likely to weather a recession, or by buying options that pay out if the main investment fails.
The Bottom Line
Investors use hedging strategies to reduce the downside risk of their investments. Diversification, options strategies, and correlation analysis are some of the most effective strategies for creating a balanced portfolio. The most effective hedging strategies reduce the investor's exposure to market risk, without harming the opportunity to make a profit.
