Hedging
Also known as: hedging strategies, hedge
Hedging is the practice of taking an offsetting position — often with options — to protect an existing investment against loss. It works like insurance: the hedge costs something up front but limits downside if the market moves against you.
Hedging means reducing the risk of an existing position by adding a second position that profits when the first one loses. The goal is not to maximize gains but to cap potential losses. Like an insurance policy, a hedge has a cost — a premium paid or upside surrendered — in exchange for protection.
The classic option hedges pair stock with an option on the same security. An investor who is long stock buys a put (a protective put), locking in the right to sell at the strike price no matter how far the stock falls. An investor who is short stock buys a call, capping the price they might have to pay to buy shares back. In each case, the option premium is the cost of the protection.
Options can also generate income with partial protection. Selling a covered call against long stock brings in premium that cushions a small decline, though it caps upside and leaves substantial downside exposure. Exams distinguish full hedges (buying options) from partial hedges (selling options): buying an option provides the best protection, while writing one only offsets losses by the premium received.
Hedging appears throughout the securities exams. The SIE tests basic hedging strategies, the Series 9 tests hedging and suitability in depth, and the Series 66 covers option hedges within derivatives. Know which option hedges a long or short stock position, the breakeven math, and when a hedge is suitable for a client.
Key takeaways
- Hedging uses an offsetting position to limit losses on an existing investment, trading some cost or upside for protection.
- Long stock is fully hedged by buying a put; short stock is fully hedged by buying a call.
- Selling options (like covered calls) provides only partial protection, limited to the premium received.
- A hedge functions like insurance: the premium is the cost of shifting risk.
- The SIE, Series 9, and Series 66 exams all test option hedging strategies and their breakeven points.