“Hedging” gets tossed around in casual conversation, but in finance it has a precise meaning: reducing your portfolio’s exposure to a risk factor. You always hedge against something—an uncertain event that could hurt your returns. Most of us already hedge in daily life (“hedging your bets”). Yet mass‑market portfolios rarely include a true hedge, leaving retail investors exposed to surprises.
What is hedging?
Hedging. Hedging is a word that’s usually thrown around colloquially, but very rarely properly understood in a technical financial sense. Rather than shaping a large bush in your front yard, hedging is the act of reducing the exposure of your portfolio to a given factor.
The term hedging is most accurately used as ‘hedging against’ x, where x is an uncertain event that can cause a reduction in utility or benefit to a given investor or person. Hedging your bets is common in daily life, both as an expression and habit, yet, the portfolios offered to retail investors en masse today don't offer any hedging strategies to reduce unforeseen risk.
Hedging examples
For most events that can cause an adverse reaction, there is usually a hedge.
Investors frequently hedge against earnings reports for public companies that they have exposure to using options. For protection against the stock dropping precipitously if they are long, they would buy a put option (essentially an insurance contract against the stock). If they are short, they would buy a call option, the right to buy a stock at a given price to neutralize their exposure up to a given point (the strike price).
Airline companies use futures to hedge against increases in fuel prices. Airlines are companies with historically low margins as heavy competition has practically commoditized commercial flight. In order to protect precious margins from rising fuel costs, they buy fuel futures, which locks in the price of fuel in advance to reduce volatility of the income that flows to the bottom line. A ‘future' is the forward purchase of an asset sometime in the future.
Unemployment insurance can also be considered a hedge, hedging against running out of money if you lost your job. A certain amount of your W2 paycheck is withheld and paid into what is essentially an unemployment insurance fund. The withheld amount would be considered your ‘premium’ payment (just like how you would pay on your car insurance), and if you were to lose your job, you make a ‘claim’ (as you would if you had an insurable event happen to your car).
Tactical asset allocation hedges your portfolio by rebalancing into less risky assets in times of projected market volatility and into higher returning assets when market signals point upwards. This is a hedge against overall volatility rather than a specific event for a specific ticker. In the same way that the put options that we previously discussed prevent a position in one company from falling below a certain level (the strike price), a tactically managed portfolio would remove a portion of portfolio volatility by moving assets into a ticker like BIL (short term government bonds with a 3 month maturity, known for practically 0 volatility).
How to construct a hedge
The first thing that you need to do when constructing a hedge is to think about the maximum loss that you are willing to accept.
Steps to construct a hedge
- Understand the position of value
- Understand the risks affecting said value
- Understand the instruments available to you to construct that hedge
- Determine your max loss
- Enter the hedging position
Understand the position of value
Hedging everything is not a good idea. If it’s 2025 and you just bought an iPhone 4, does it make sense to purchase Apple Care, to insure an almost worthless asset? Probably not. Say you keep your life savings in a single company (which you should never do) and you are buying a house in 2 months and you absolutely need the money ready, that is worth hedging against.
Understand the risks affecting that value
Using the above example of your life savings in a single company, that major risk is the stock price of the company aggressively dropping because of a given event, usually earnings.
Understand the instruments available to you to construct that hedge
Again using the above example of keeping your net worth in a single company with a hotly anticipated earnings report coming up soon, an instrument to do so would be an insurance contract (put option) with an expiration date the day after earnings.
Determine your max loss
Not all hedges are created equal. For absolute protection against a stock falling in value, one would purchase an at-the-money put option for a long position (at-the-money call option for a short position). Continuing with the insurance analogy, the deductible of this insurance contract is practically 0, which is why the premiums are the most expensive.
If you were willing to take a higher deductible and pay less of a premium, you would purchase a put option (for a long position) that is lower than the current stock price for less than the at-the-money option.
Enter the hedging position
Once your max loss and hedging budget is understood, it’s time to place the trade (in the example of options or futures) or contact your insurance provider (in the case of traditional insurance for a house or car), or shift a portion of your portfolio into risk-off assets (in the case of tactical asset allocation).
Important considerations of hedging
There is a cost to everything. Insurance, technically speaking, is a transfer of risk. No one is going to take on extra risk without payment. This payment from the portfolio holder for the hedge will eat into returns. If you were to insure a long position in a stock that appreciates in the long term at all times with the most expensive at-the-money put options, the overall portfolio return would be drastically lower than with a non-hedged portfolio. Smart investors hedge when the reduction in volatility is worth the payment for doing so, usually for short-term events.
Does your portfolio hedging work? How to evaluate the efficiency of returns
The Sharpe ratio is another frequently used little understood term that reflects an important investment performance metric. Literally defined as the return above a risk-free investment per unit of volatility, it essentially describes the skill of an investment manager.
This is a great metric to quantitatively tell if an investment manager that employs hedging is skillful at his job, or overly nervous. If a manager over hedges and pays too much for portfolio insurance, his Sharpe ratio will be low or even negative because the returns will be lower than an investment with no risk. The sweet spot is an investment portfolio that returns the same amount as a general market portfolio, but with much lower swings.
Fun fact: the original term ‘hedge fund’ was used to describe a fund that had low correlation with the rest of the standard investment universe, a fund whose returns would act as a portfolio level hedge so when the rest of traditional investments did poorly, the fund would outperform (think Michal Burry in the Big Short doing 100s of percent return when the bottom fell out of the rest of the market in 2008). Having a position in Burry’s hedge fund would ‘hedge’ or cushion the drop in the overall portfolio value (assuming a position in Burry’s fund) from the madness of the Great Financial Crisis.
The dangers of static hedging
Some retail investors hedge their portfolio against downturns by keeping a small portfolio of their portfolio in inverse ETFs, like SH, a 1x inverse of the S&P500. However, this is a dangerous drag on returns over the long term. In bull markets, losses accumulate on the inverse ETF. The only time that this ETF is actually useful for a hedging strategy is when the market drops immediately after the hedging position is taken.
However, using inverse ETFs within a tactical asset framework can be a valuable return-add and volatility reducer to the portfolio. Just like how Sidepocket’s tactical strategies are careful to not overallocate to risk-off assets like government bond funds over the long term, it’s important to take these hedging positions only over short periods of time based on market signals. Rebalancing the portfolio into these hedging positions when signals arise and rebalancing out when they fade is key to preventing short term losses, minimizing return opportunity cost, and tracking the benchmark upwards in bull markets.
Hedging at the portfolio basis
Instead of hedging a single exposure, it frequently makes sense to hedge an entire portfolio against excess volatility.
It is common for most young high earners to put all their capital into a ticker like QQQ, an ETF proxy for the Nasdaq-100. This ETF tends to be tech-heavy increasingly with the massive equity value of companies like NVDA, MSFT, and AAPL, and extremely volatile.
While young high earners can withstand the volatility, it makes sense to ask: am I getting paid to withstand this volatility? What if you suddenly need the cash, and you’re going through a (needless) drawdown because you’re overexposed to volatility? Since October of 2011, the Sharpe ratio of QQQ (return per unit of price standard deviation) is 0.90, which means that you are getting paid roughly 0.90 cents for each yearly dollar of price movement.
Compare this to Sidepocket’s models, namely the Speculative model, which is benchmarked to QQQ. Instead of a 0.905 Sharpe ratio, our speculative model features a Sharpe ratio of 1.03, meaning that our models return 15% more return per unit of volatility versus the benchmark. We do this by shifting some of the portfolio to less-risky assets like government bonds based on our market strength signals, so when there is a large sell off in risky assets and money flows into risk-off assets, our portfolio drops in value less than a portfolio 100% in risky assets.
In short, we win more by losing less, which is critical because when a portfolio drops 50% in value, it must double to get back to 0% return.