Generally, when investors consider risk they focus on market risk and how an adverse movement in a stock or the broader markets will affect their portfolios. Market risk can be defined as the chance that an investment’s actual return differs from its expected return.

A basic measurement of risk in a specific market, known as volatility, is the standard deviation of the historical returns or average returns of a specific investment. High standard deviations indicate a high degree of risk.

A key component of the risk management process is risk assessment, which involves the determination of the risks surrounding an investment. One of the basic ideas of investing is the relationship between risk and reward.  Returns are considered a function of risk in that the greater the risk, the greater the potential for reward.  The reason for this is that investors need to be compensated for taking on additional risk.

For example, Certificate of Deposit at a bank is considered to be one of the safest investments and, when compared to common equity, provides a lower rate of return. The reason for this is that a corporation is much more likely to go bankrupt where the common stock would be worthless. Because the risk of investing in a CD is principal protected by the FDIC, the risk of owning a CD is very low, and therefore pays a low return.

Related: How to Minimize Investment Risk

Hedging Risk

When investors assume risk in an asset class that has a premium above a risk free rate of return, the investor could consider hedging the exposure when the returns are better than expected and lock in profits.

Investors can hedge risk exposure in many ways.  An investor can use options on the specific asset, or a financial instrument that somewhat mimic the market direction of the asset that is owned.

For example, if an investor owned Apple Stock, and wanted to lock in some of their profits after the stock moved from $500 to $600, they could hedge their risk exposure by either selling a portion of their position, or selling an another instrument such as the Nasdaq 100.  The Nasdaq 100’s returns are highly correlated to those of Apples, which would allow an investor protection from a downward movement in Apple’s share price.

Another type of hedge that an investor could undertake would be to use options to mitigate market risk.  For example, a put option provides downward protection against long stock positions.  Buying Apple puts would mitigate some of the downside risks as the investor owns the right, but not the obligation, to sell Apple stock at a specific price.  The market risk of a put is limited to the delta of the put.

Another way to hedge downside risk using options would be to sell a call option.  In this case an investor would receive a premium which would protect a portion of a downside move.

An example of covered call hedging is as follows.  An investor could sell a “at the money” call in Apple stock that expires in 60 days would pay the investor $35 dollars.  With the current stock price at $605, the investor would be protected down to $570 ($605 – $35).  If the price of the stock is above $605 when the call option expires, the investor would have his stock called away at $605, but would be essentially taking profit at $640 ($605 = $35).

Related: Understanding and Hedging Interest Rate Risk

Hedging Pitfalls

When an investor hedges a position as opposed to taking profit or stopping out of a position they are increasing their basis risk while mitigating their market risk.  If an investor decides that he would like to mitigate the risk of an adverse downward movement, by selling an instrument that is similar, such as the QQQ (nasdaq 100 trust) against a long position in Apple stock, the investor has offset the direction risk of Apple, but taken on a basis risk between Apple and the Nasdaq.  Although the likelihood of a large basis movement is rare, investors should be aware that this type of spread could move against them.

When trading options as a hedge, an investor needs to be aware of the risk associated with options.  Protective puts are excellent tools, but they have a component which determines a large majority of the cost of the option which is implied volatility.  When markets are already volatile, the cost of protection can be prohibitive.  When volatility is high, selling covered calls is a sound strategy, but this will only protect an investor to the extent of the premium received, which might not cover a large drop in the price of the underlying stock.

Hedging risk exposure is an important concept in portfolio management and investors should be aware of all the tools available when trying to mitigate portfolio risk.