What Is De-Hedging?
De-hedging is the act of unwinding positions initially established as hedges in a trade or investment portfolio. A hedge is essentially a protective measure, taken to minimize potential losses in an existing position or investment.
The process of de-hedging can be executed in different ways. It might happen all at once, with the complete removal of the hedge in a single transaction. Alternatively, it can be done incrementally, where only a portion of the hedge is removed at a time, leaving the position partially hedged. This approach allows for a gradual adjustment to the risk profile of the portfolio or trade.
How De-Hedging Works
De-hedging involves going back into the market and closing out hedged positions, which were taken to limit an investor’s risk of price fluctuations in relation to the underlying asset.
For example, investors might de-hedge when they have a bullish outlook on an asset they hold, anticipating an increase in its value. By de-hedging, they aim to fully capitalize on the expected upward price movements.
Consider an investor who has hedged their investment in gold. If they believe gold prices are poised to rise, they might buy back any gold futures contracts they previously sold. This action removes the hedge, positioning them to benefit from a potential increase in gold prices, should their bullish forecast prove accurate.
De-hedging can also be a response to the success of the hedge itself. If the hedge effectively protected against a substantial price decline, the investor might choose to lift the hedge to allow the underlying asset to rebound from its lower value, or they might decide to exit the position altogether. This approach allows them to either benefit from the recovery of the asset or to realize the gains from the successful hedge.
De-Hedge vs. Hedge
A hedge is like insurance for your investments, helping to lessen the impact of any negative price changes. Often, this involves taking a position in a related security, like a futures contract, which moves in the opposite direction to your main investment.
Hedging is a balance between safety and profit: it can lower your risk, but it might also reduce how much you could earn.
Derivatives are financial products that change in value based on something else, like stocks, bonds, commodities, currencies, or interest rates. They include options, swaps, futures, and forward contracts. Using derivatives as hedges can be very effective because they have a known relationship with the asset you’re protecting.
Using derivatives for hedging can help pinpoint risks better but might require more know-how and money. But derivatives aren’t the only way to hedge. Simply spreading your investments across different areas to lower risk can also act as a basic form of hedging.
Why Investors Hedge and De-Hedge
Portfolio managers, individual investors, and corporations use hedging to lessen their exposure to various risks. But in financial markets, hedging is more complex than just paying an annual insurance premium.
Hedging against investment risk involves carefully selecting financial tools to counteract potential adverse price movements. Essentially, it means balancing one investment with another.
The primary aim of hedging isn’t to earn profits but to safeguard against losses. The expense of hedging, whether it’s the cost of buying an option or the potential lost gains from being on the wrong side of a futures contract, is an inevitable aspect. This expense is considered the necessary cost for reducing uncertainty in investments.
Example of De-Hedging
Commodity Trading Firm XYZ believes that the price of wheat will rise from $100 per ton to $150 per ton in the next six months. To capitalize on this prediction, it buys 50 wheat futures contracts at $5,000.
Simultaneously, due to potential adverse weather forecasts which could negatively impact wheat crops and lower prices, XYZ decides to hedge its position. It buys 10 wheat futures contracts at $1,000 as a protective measure. If the price of wheat rises to $150 in six months, XYZ stands to gain $2,500 from its main position but would incur a $200 loss on its hedge, netting a total profit of $2,300.
However, three months into the trade, weather conditions improve significantly, easing concerns about crop damage. Consequently, wheat prices increase to $120 per ton. XYZ then opts to de-hedge by closing its short position. At this point, the loss from the hedge is reduced to just $80.