What is hedging?

Stock trading question from Steve L.: “Can you explain hedging in laymans terms?”

To hedge means to protect a position or portfolio without exiting it. For example, if you had a $100,000 share portfolio that was designed for dividend income and you were concerned that a major correction may occur but didn’t wish to trigger a tax event, then you could hedge the portfolio. Doing so will ensure you protect the capital but retained the positions. When you felt the threat of a correction was alleviated you could then remove the hedge.

In years gone by hedging was a little cumbersome for most investors and required the use of futures or options. Sometimes these required a second account with another broker, or the nature of their composition didn’t make them a suitable ‘best fit’ to hedge properly, especially for smaller portfolios under $250,000. Futures contracts are ‘standardized’ and tended to have a larger underlying value. Options are limited in range and using them introduces other risks, such as time and volatility decay.

Nowadays we have CFDs which enable a perfect hedge. If you have $10,000 worth of ANZ shares, you can hedge exactly that $10,000 amount for example. You can easily hedge partial exposure by selling $5000 and remaining exposed to the other $5000 until the threat subsides. Also, some brokers, such as Macquarie Prime, offer CFDs and straight shares on the same platform meaning capital doesn’t have to be moved around.