Over-hedging

Over-hedging refers to a flawed type of protective activity aimed at reducing possible losses in the spheres of investment and finance. This is a form of managing risks involved with investing in securities, which is realized through creating differently directed positions for a security, with the position intended at minimizing potential loss being excessively larger than the original position, thus imposing additional risks. In many cases, over-hedging isn’t intentional, although sometimes it’s used on purpose as a part of a complex strategy.

Over-hedging main features

In general, a practice of hedging is widely used and is rightly seen as a useful tool for reducing losses, which are inevitable if an investor has a diverse portfolio with many positions. Losses might occur, and are especially likely to happen when a security’s volatility increases, so it’s considered a wise move to make a hedge investment for highly volatile securities.

Hedging is often performed via the use of derivatives, such as options, futures, etc. By purchasing derivatives, an investor creates a position which is opposite to the position being hedged. For example, let’s assume a situation when an investor has 100 shares of a stock with a total price of $500. It’s possible that the price of this security might decrease significantly, so the investor buys options for the same asset, expiring in a year, with a total premium of $50. Let’s imagine that those options provide a possibility to sell the asset at a strike price which is little less than the initial price at which the investor purchased the security. So if the security price drops significantly during the following year, decreasing below both the initial price and the strike price of the option, the investor can exercise the option and sell the security. The investors still incurs a loss in this case, but the loss is notably less than it would be without hedging because otherwise the investor would lose the whole invested sum.

The situation described above refers to a regular hedging practice. Over-hedging occurs when a position created for hedging purposes is notably greater in amount than the original one.

Over-hedging negative sides

Hedging in general cuts down the profits, but in case of reasonable hedging it’s considered to be an acceptable cost of insuring, while with over-hedging it might affect the profits too much.

Another kind of risk exists in case an investor over-hedges by using a put option for the security amount he or she doesn’t actually possess. It means that in case it’s necessary to exercise the option, the investor has to buy the lacking amount at a higher price before selling it at a strike price, which magnifies the losses, sometimes to an amount of hedging being practically senseless in that case.

For the reasons described above, over-hedging is often viewed as an inefficient way to manage risks. As over-hedging often happens accidentally, it’s crucially important for investors to thoroughly examine the available information on securities and general market conditions before hedging. All in all, hedging techniques are still a functional way to manage risks and reduce losses, and it’s generally agreed that an improperly performed hedging is actually safer than a total lack of preventive mechanisms at all. 

Alternatives to Over-hedging

As hedging is not a single way to protect investments from the effects of dramatic price decreases and market volatility, a lot of investors are strongly encouraged to combine hedging practices with alternative protective mechanisms. If an investor has a considerable experience in the market, it’s often a good move to diverse a portfolio by adding new positions and optimizing it in a way that might compensate possible losses from highly volatile assets by steady profits from other securities. 

Another popular piece of advice, which is often given to investors by professional consultants, is that long-term investment strategies are preferable to use from the perspective of risks management, as short-term investment strategies are more vulnerable to the market volatility. Constant monitoring of the market, observing and analyzing all the available data are also inevitable parts of minimizing risks, so all the activities described above might be combined with hedging for better results, as well as the use of specialized software and applications for calculating, assessing and planning.