What Is a Short Hedge?

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DEFINITION
A short hedge refers to a strategy investors and companies can use to protect themselves from losses due to the anticipated or real decline in an asset they own or produce.

A short hedge refers to a strategy investors and companies can use to protect themselves from losses due to the anticipated or real decline in an asset they own or produce. Short hedging often involves selling a futures contract. For example, farmers sometimes do this to protect themselves against losses in the commodity they produce.

Let’s take a closer look at short hedges, with a focus on how and why they can matter to individual investors.

Definition and Examples of a Short Hedge

A short hedge generally occurs when an investor purchases a put option for the asset they already have. You can also sell futures contracts to conduct a short hedge, but this is a relatively complicated strategy and not as relevant to individual investors.

Let’s assume you own 100 shares of a stock that you believe will soon go down in price. To protect against an anticipated drop, you purchase a long put option (100 shares) to hedge against your losses. A long put option becomes profitable—generally speaking—as the underlying equity decreases in price.

How a Short Hedge Works

A common short hedge occurs when an investor purchases a put option alongside a stock they plan to hold for a long time. The put option acts as a sort of share-for-share insurance if your stock price goes down. In theory, the stock price dropping doesn’t cost you any money.

Say you have 100 shares of a company at $50 per share, and you buy a put option as a short hedge. When you execute a short hedge by getting a put option, you give yourself the right to sell shares in the underlying stock at the option’s strike price on or before the option expiration date. For example, if you buy a $50 put option with a December 2020 expiration date, you can sell the stock at $50 per share on or before the December 2020 expiration.

This is considered a bearish trade because you would hope to sell the stock at a price higher than market price. So in the above scenario, if the underlying stock sells for $45, you could sell 100 shares for every put you purchased for $50, representing a $5 per share profit (minus the put price and premiums). You also have the option to sell the put contract as the premium increases, which—everything being equal—happens as the underlying equity decreases in value.

Types of Short Hedges

Buying a put option (which indicates short sentiment) represents one way to hedge against downside. However, this strategy only works for individual stock positions. If you want to guard against the decline in value of your overall portfolio, you could use one or more of the following strategies.

General Market Index Put Options

One way to approach a short hedge is to purchase a put option on a general market index, such as the S&P 500 or Nasdaq, particularly if the composition of your portfolio closely resembles that of the index. However, it might be difficult for many individual investors to make this determination, rendering the position short one segment of the market instead of the original purpose of hedging against downside in your specific set of holdings.

Additionally, during periods of considerable stock market volatility, put option premiums on these indices might be prohibitively expensive. This turns what you might have wanted to be a simple, straightforward hedge into an advanced strategy, given that it’s difficult for many individual investors to assess volatility as it relates to the cost of an option contract.

Short Selling

You can hedge a long stock position by short selling the same stock. The problem with short selling, particularly for inexperienced investors, is that you could lose your entire investment. This is not possible when you purchase a put option. Your losses on a put option can go no higher than whatever it cost you to purchase the premium. You also must maintain a specified margin level if you decide to short stock in your account.

Inverse ETFs

To hedge against your portfolio or a set of holdings within your portfolio, you could purchase an inverse ETF. An inverse ETF aims to generate a return that’s the inverse of the stock market index it tracks. For instance, generally speaking, an inverse S&P 500 ETF would increase in value as the actual S&P 500 decreases in value, or vice versa. Some inverse ETFs use leverage and look to return inverse performance that is multiples, say two or three times, of the index it tracks.

Is a Short Hedge Worth It?

Whether or not a short hedge is worth it depends on several factors. If you’re holding a stock for the long term, it might make sense to do nothing, even in the face of anticipated downside. In some respects, buying a put because you think a stock you own might go down is akin to timing the market. This isn’t easy to do.

You might anticipate a decline in a stock price ahead of an earnings report or some other event so you decide to—essentially—invest in protection. Whether or not this is worth it depends on your aversion to risk and other factors affecting your outlook on investing and your portfolio.

If you’re wrong and the stock price rises, you profit on the stock position but end up with a worthless or near-worthless put option. You’re also out the cost of the premium. If you’re correct and continue to hold the long position, you suffer on-paper losses on the stock and could realize profits by selling your put option for a higher price than what you paid for it. To exercise the put, you’d need to sell your stock, which means you’d then have to rebuy it to reenter the long position.

While both of these outcomes can generate a profit, many factors, including implied volatility, affect the price of an option. These intermediate to advanced elements of using options can make a seemingly straightforward strategy—buying a protective put—complicated.

If you’re not exactly sure how options function, or the downside you anticipated quickly evaporates as your stock bounces back, it might not be worth the time and cost to execute a protective put.

As with any investment strategy, you need a full understanding of not only how inverse ETFs function, but of the costs, fees, and tax consequences of using the product.

What It Means for Individual Investors

As with any investment strategy, your level of experience, risk profile, and short- and long-term financial goals dictate whether or not you should use hedges against your long positions.

If you’re holding stock positions for the long term, it might not make sense to hedge against a temporary price drop. In this case, you might be better off buying the dips.

Alongside this strategy, you might use dollar-cost averaging. This simply means purchasing shares of an asset on a regular basis so that you buy more shares when the price is low and fewer shares when the price is high.

This said, if you’re concerned about or simply want to profit from broad market declines or downside in a particular stock, you might consider putting on a hedge. While put options remain the most straightforward tool, individual investors can use other strategies to hedge their long positions.

Key Takeaways

  • Investors use short hedges to protect themselves against losses in their long positions.
  • Buying put options represent a popular and straightforward way to put on a short hedge.
  • Even though this type of hedge means you’re long the put option, you’re still making a bearish bet, thus expressing short sentiment.
  • Other ways to hedge individual positions, a subsection of your holdings, or your entire portfolio exist; however, investors should proceed with caution, given the complexity of strategies such as short selling and using inverse ETFs.

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