Hedging is the practice of purchasing and holding securities specifically to reduce portfolio risk. These securities are intended to move in a different direction than the remainder of the portfolio — for example, appreciating when other investments decline. A put option on a stock or index is the classic hedging instrument.

When properly done, hedging significantly reduces the uncertainty and the amount of capital at risk in an investment, without significantly reducing the potential rate of return.

How It’s Done

Hedging may sound like a cautious approach to investing, destined to provide sub-market returns, but it is often the most aggressive investors who hedge. By reducing the risk in one part of a portfolio, an investor can often take on more risk elsewhere, increasing his or her absolute returns while putting less capital at risk in each individual investment.

Hedging is also used to help ensure that investors can meet future repayment obligations. For example, if an investment is made with borrowed money, a hedge should be in place to make sure that the debt can be repaid. Or, if a pension fund has future liabilities, then it is only responsible for hedging the portfolio against catastrophic loss.

Downside Risk

The pricing of hedging instruments is related to the potential downside risk in the underlying security. As a rule, the more downside risk the purchaser of the hedge seeks to transfer to the seller, the more expensive the hedge will be.

Downside risk, and consequently option pricing, is primarily a function of time and volatility. The reasoning is that if a security is capable of significant price movements on a daily basis, then an option on that security that expires weeks, months or years in the future will be highly risky, and therefore, costly.

On the other hand, if the security is relatively stable on a daily basis, there is less downside risk, and the option will be less expensive. This is why correlated securities are sometimes used for hedging. If an individual small cap stock is too volatile to hedge affordably, an investor could hedge with the Russell 2000. a small cap index, instead.

The strike price of a put option represents the amount of risk that the seller takes on. Options with higher strike prices are more expensive, but also provide more price protection. Of course, at some point, purchasing additional protection is no longer cost effective.

Example — Hedging Against Downside Risk

• The SPY, the S&P 500 Index ETF. is trading at 147.81
• Expected return by December 2008 is 19 points
• Put options available, all expiring December 2008