What is Hedging?
Hedging is analogous to taking out an insurance policy. If you own a home in a flood-prone area, you will want to protect that asset from the risk of flooding—to hedge it, in other words—by taking out flood insurance. In this example, you cannot prevent a flood, but you can work ahead of time to mitigate the dangers if and when a flood occurs.
There is a risk-reward tradeoff inherent in hedging; while it reduces potential risk, it also chips away at potential gains. Put simply, hedging isn't free. In the case of the flood insurance policy example, the monthly payments add up, and if the flood never comes, the policy holder receives no payout.
Still, most people would choose to take that predictable, circumscribed loss rather than suddenly lose the roof over their head.
So, what are types of hedging strategies?
Standard Hedge
The most common way of hedging in the investment world is through derivatives. Derivatives are securities that move in correspondence to one or more underlying assets. They include options, swaps, futures and forward contracts. The underlying assets can be stocks, bonds, commodities, currencies, indices or interest rates. Derivatives can be effective hedges against their underlying assets, since the relationship between the two is more or less clearly defined. It’s possible to use derivatives to set up a trading strategy in which a loss for one investment is mitigated or offset by a gain in a comparable derivative.
As explained earlier the hedge acts like and insurance agaisnt the risk of your portfolio. You can choose to insurance all or just a portion of it.
Specifics of these are best discussed with your Advisor directly as everyone has a different risk profile.
Tail Hedging
Tail hedges are one way to potentially limit losses in adverse markets. They may better enable investors to stick with their positions through bad times and thus be long-term. Tail hedges may even create potential for investors to opportunistically pick up risky assets in times of market distress (often at fire-sale prices).
Whether one is reducing their equity exposure permanently via a fixed asset allocation or temporarily in the context of market timing, it affects the composition of the overall portfolio. However, TRH (a.k.a. black swan) strategies are typically concentrated within a smaller allocation comprising less than 5% of the overall portfolio. This allows one to retain 95% or more of their standard portfolio exposures. Specifically, this helps avoid the potential emotional rollercoaster associated with wholesale changes to the portfolio.
There are 4 key factors when executing a TRH Strategy. Timing, Precise Risk Targeting and Cost of Certainty. All of these are too vast to go into here but one of our Advisors would be happy to walk you thru the complexities of Tail Risk Hedging to detemine if it is a fit for you.