Over-Hedging

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Over-Hedging Definition

Over-hedging refers to a hedging strategy to offset losses by taking an offsetting position against the original position, and the offsetting position size is larger than the original position. In simple terms, placing an opposing bet so much identical to the original one minimizes the risk.

It is a risk management strategy common in the financial markets. For example, an investor can buy a fixed number of shares of a stock and at the same time buy a put option to sell more shares of the same stock; if the price of the shares bought falls, the put option act as a protective measure.

Over-Hedging Definition

Over-hedging is a hedging strategy for risk management in which an offsetting position of greater size hedges the original position.
It is often considered an ineffective application of hedging strategy to create a net position in the opposite direction, which can also happen by mistake, creating additional risk.
If an investor bought n number of shares of a stock and then bought a put option enabling him to sell more than n number of the same shares, it portrays an example.
Example of its applications is over-hedging barrier options and currency over-hedging.

Over-Hedging Explained

Over-hedging act like insurance for investments by strategically setting positions to avert investment risks. It can minimize the market risks and prevent investments from being affected by the negative impacts of a downtrend. Portfolio managers, corporations, and individual investors apply it to reduce the risk due to price decline. Its usage is very common in the oil or fuel industry. Other common applications are over-hedging interest rate swaps, currencies, and barrier options.

In one way, it is explored as being over-protective about investments and affecting the original position's profit potential. Any investment hedged by an offsetting position will only work if a negative event like a price decline occurs. Even after placing an offset position, there are chances for the investment to incur a loss. It is inherent that every hedging strategy has a cost associated with it, and the advantages must justify the expense incurred.

Examples

Suppose, in a hypothetical situation, during a high school football game, Kevin places a bet of $500 on team A winning and then places another bet with another group of friends, placing a bet of $510 on team B winning. In this situation, the chances of Kevin losing the money are minimized but, at the same time, defeats the purpose of winning the bet or registering a profit.

Tweaking the first example, if Kevin has his original bet of $500 on team A winning and places a small bet of $200 on team B winning, it is called under-hedging. Here if team A wins, Kevin will earn $500 but will pay $200 for his second bet making a net profit of $300, and in case team B wins, Kevin will earn $200 but will have to pay $500 for his original position making a net loss of $300. Hence, it is a contrasting strategy to over-hedging.

Consider another example. Investor A decides to purchase 100 shares of ABC company stock to enter into a long position. However, fear of market volatility made him purchase a put option to sell more than 100 shares of ABC. This provision saves the 100 shares from making a loss because if the price falls below the strike price, which is greater than or equal to the per-share value, it exercises the put option, and to complete the put option transaction, the investor A has to arrange for the additional shares in the put contract and there the risk happens.

How to Stop Over-Hedging?

Create a good portfolio when a trader invests in a pool of stocks and assets. They should do proper research on technical indicators, market trends, and prospects so that their portfolio is optimized, diversified, and generates enough returns to avoid hedging as a strategy to avert risks.
Focus on long-term investment strategies rather than strategies focusing on short-term gains because the short-term gains invite high risk due to volatility in the market.
Use professional services for implementing hedging strategies to avoid mistakes.
Use alternative hedging strategies.

Frequently Asked Questions (FAQs)

What does it mean to hedge against something?

Hedging is a protective measure or investment against possible losses. It is common in financial markets where investors hedge one investment or position by conducting another trade. This risk management strategy comes with a cost like a premium paid for buying it. Hedging strategies are commonly used in the securities and commodities market.

What is over-hedging?

It is a risk management method that uses a hedging technique. It occurs when a trader takes an offsetting position against the original position, but the magnitude of the offsetting position is bigger than the original position.

What is under-hedge?

Under-hedging means establishing an offsetting position but not balancing the original position. In this type of strategy, there are more chances of losing money because the offsetting position is not fully utilized to cancel out the original position. The loss is lowered, but still, there is a loss.