How to Hedge Your Stock Investments

The stock market has performed extremely well in the last decade or so, surpassing even the expectations of the most optimistic investors. However, bull markets cannot last forever as we have seen from the past. Eventually, a market correction is bound to occur.

As long-term investors, we should focus on the long-term prospects of the company and try to ignore any short-term market fluctuations. Having said that, some investors might still opt to decrease the risk of short-term market rebounds and hedge their bets accordingly.

With this in mind, I have listed three common ways that investors may choose to hedge their stock investments.

Have a portfolio of “short” stocks positions

When an investor acquires a “short” position on a stock, they, in essence, are banking that the stock will decrease in price. Short selling a stock can act as a good hedge against an overall bear market and investors can also profit when an overpriced stock finally tanks and returns to its true intrinsic value.

At the same time, short selling a stock can also be a risky investment. Because a stock can theoretically appreciate more than 100% in price, an investor can potentially lose more than his initial investment. Therefore, investors should proceed with caution when employing such a strategy.

Ensure your portfolio is diversified among other asset classes

Having a diversified portfolio is essential in decreasing your overall investment risks. For instance, the price of bonds and stocks move in opposite directions. As such, having a portfolio of bonds along with your stocks can help hedge against any stock market downturns.

Investors can also choose to diversify into other asset classes such as commodities and real estate as they are not closely related to the stock market. This allows them to deviate some of the risks.

Use derivatives

Derivatives provide investors with a cheap alternative to shorting a stocking.  There are a few derivative options available such as selling call options or buying a put option contract that allows you to profit from falling stock prices.

Many long-term investors might think of derivatives as pure speculation but if used correctly, derivatives can be a useful hedge and can also be a useful method to earn extra income.

The Foolish bottom line

Some investors may think that hedging your investments is only useful for speculators who lack conviction with their investments. In reality, hedging is a common technique used by hedge funds and big companies to reduce their risks. Even individuals can consider hedging their investments so that they can profit even in an economic downturn.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.