![]() ![]() Supporting documentation for any claims, if applicable, will be furnished upon request. Before trading options, please read Characteristics and Risks of Standardized Options. Certain complex options strategies carry additional risk. Options trading entails significant risk and is not appropriate for all investors. While diversification does not guarantee against a loss, it is likely the more effective risk management tool compared with hedging for most regular investors. Diversification can help protect you against the idiosyncratic risks of individual stocks. Hedging that risk exposure may not make sense, due to the costs involved with hedging, if your intention is to hold the stock over the long term.Ĭonsequently, you may want to manage your investments so that you have a diversified mix that aligns with your investing objectives and risk constraints. After a couple months, you believe the stock may be exposed to the risk of loss over the short term. For example, suppose you purchase a stock with the intention of owning it over the long term (i.e., more than a year). Hedging may not make sense for long-term investors. Also consider an investor that purchases a diversified mutual fund or ETF: If you believe that components of the fund may be exposed to the risk of loss, you may not be able to easily hedge only those components of the fund. Consider the example of an airline that hedges airline jet fuel costs, only for future jet fuel to be less expensive after the hedge is implemented. Hedging may not be effective, even if it is implemented as intended by the hedger. ![]() Taking on another position (such as buying options) involves a cost. You would need to fully understand the hedging instrument in order to consider utilizing hedging. ![]() Hedging typically involves advanced investment vehicles (relative to traditional investments, such as stocks and bonds). But it's important to know that hedging can be a double-edged sword-specifically, if the investment used to hedge loses value or it negates the benefit of the underlying increasing in value.įor individual investors, hedging may not be the best course of action-for several reasons: Without hedging, airline operators would have significant exposure to volatility in oil price changes.įor many businesses and professional investors, hedging can be an important tool to help meet their objectives-particularly for those that have the necessary resources (e.g., employees with the skill and experience needed to understand and execute hedges). Airlines hedge costs, in large part, so that they are better able to budget future expenses. A common example of this type of hedging is airlines buying oil futures several months ahead. Unrelated to individual investors, hedging done by companies can help provide greater certainty of future costs. You may not want to have a taxable event created by selling a position. You may have significant exposure to a specific investment (e.g., company stock) and you want to hedge some of the risk. Assuming you think your trade will go in the opposite direction than what you want over some period of time, there can be a variety of reasons why you may want to hedge rather than close it out, including: The primary motivation to hedge is to mitigate potential losses for an existing trade in the event that it moves in the opposite direction than what you want it to. You can learn more about trading options here. In this scenario, you would be protected from additional losses below $20 (for the duration of owning the put option). Suppose you purchased put options sufficient to hedge your existing position with a strike price of $20. Puts grant the right, but not the obligation, to sell the stock at a given price, within a specified time period. To hedge this position, you might consider a protective put strategy-purchasing put options on a share-for-share basis on the same stock. Assume that you do not want to sell the stock (perhaps because you still think it might increase over time and you don't want to incur a taxable event), but you want to reduce your exposure to further losses. Several months later, the stock is trading at $25. Suppose you purchased 100 shares of XYZ stock at $30 per share in January. Let's look at a hypothetical hedging example. That is, you would not hedge a position at the outset of buying or shorting a stock. Hedging is not a commonly used trading strategy among individual investors, and in the instances where it is used, it is typically implemented at some point after an initial investment is made. Hedging is an advanced risk management strategy that involves buying or selling an investment to potentially help reduce the risk of loss of an existing position. ![]()
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