Hedging is a financial strategy that investors should understand and use because of all the advantages it offers. As an investment, it preserves an individual’s finances from being revealed to a risky situation that may lead to loss of value. Though, Hedging doesn’t necessarily mean that the investments won’t lose value at all. Instead, if it happens, the losses will be moderated by gains in another investment.
Let’s understand hedging in detail along with hedging strategies, how it works, benefits and more.
What is Hedging?
Hedging is recognising the dangers of every investment and preferring to be protected from any untoward event that can impact an individual’s finances. One obvious example of this is getting car insurance. In the case of a car accident, the insurance policy will undoubtedly shoulder at least part of the repair costs.
Hedging is a strategy used in investing to reduce the risk of losing money. It’s like when you wear a helmet while riding a bike to protect yourself in case of a fall. In investing, hedging might involve buying a variety of stocks so if one does poorly, others may do well.
Hedging in finance – how can you hedge your investments
There are various hedging strategies you can use based on the type of investments you work with.
- When trading derivatives, you can pay a modest fee for the right to sell the stock at the same price you bought it. This is known as a “put option.”
- Most investors use diversification or holding different kinds of investments, so they don’t all lose value simultaneously as a hedging strategy.
- Investing in gold is usually used to hedge against inflation because it keeps its value when the dollar falls.
Read More – Portfolio Rebalancing – Meaning and how it works
Types of hedging
Hedging is broadly classified into three types that will help investors earn profits by trading different commodities, currencies, or securities. They are:
- Forward Contract- It is known as a non-standardized agreement to buy or sell underlying assets at a set price on the date agreed by two independent parties involved. The forward contract covers various contracts like forwarding exchange contracts for currencies, commodities, etc.
- Futures Contract- It is known as a standardized agreement to buy or sell underlying assets at a set price on the particular date and standardized quantity agreed by two independent parties involved. A futures contract includes various contracts like commodities, currencies, futures contracts, etc.
- Money Markets- It is known as one of the principal components of financial markets where short term lending, borrowing, buying, and selling is achieved with the maturity of one year or less. It covers many forms of economic activities of currencies, calls on equities where short-term loans, money market operations for interest, borrowing, selling, and lending happen with a maturity of one year or more.
What are the the commonly used tools in Hedging
Derivatives
Most investors who hedge make use of derivatives. These are the financial contracts that derive their value from an underlying tangible asset, such as a stock. An option is the most regularly used derivative. It provides you the right to buy or sell a stock at a specified price in a period of time.
Suppose you bought stock. You assumed that the price would go up but wanted to protect against the loss if the price falls. You would hedge that risk with a put option. For a small fee, you would buy the right to sell the stock at the same price. If it falls, you apply your put and make back the money you invested minus the fee.
Diversification
Diversification is known to be another hedging strategy. You own an assortment of assets that do not rise and fall together. If one asset collapses, you will not lose everything. For example, many people own bonds to offset the risk of stock ownership. When stock prices fall, bond values rise. That will only apply to high-grade corporate bonds or U.S. Treasurys. The value of junk bonds drops when stock prices do as they both are risky investments.
Why is Hedging important in financial risk management
Here’s why hedging is crucial in financial risk management:
- Hedging helps protect your investments. If one asset performs badly, another might do well and balance the loss.
- It can provide a ‘safety net’ during market downturns. You won’t lose everything if a single investment fails.
- Hedging can ensure steady returns. By spreading out risk, you’re less likely to face huge losses.
- It allows you to invest in riskier assets with potential for high returns, knowing you have a backup plan.
- Hedging can help manage unexpected changes in the market. It’s like having an umbrella ready for a sudden rainstorm.
- It’s an important part of a balanced, diversified investment strategy.
What are the benefits and drawbacks of Hedging
Some of the advantages and drawbacks of hedging are:
Advantages of Hedging
Following are the various advantages of Hedging:
- Futures and options are an excellent short-term and risk-minimizing strategy for long term traders and investors.
- Hedging tools can also be made use of for locking the profit.
- Hedging facilitates traders to survive hard market periods.
- Successful Hedging provides the trader protection against commodity price changes, currency exchange rate changes, interest rate changes, inflation, etc.
- Hedging can also save a lot of time as the long term trader is not required to monitor his portfolio with daily market volatility.
- Hedging exercising options provides the trader an opportunity to practice complex options trading strategies to maximize his return.
Disadvantages of Hedging
Following are the disadvantages of Hedging:
- Hedging involves a cost that tends to eat up the profit.
- Risk and reward are usually proportional to one other; thus, reducing risk will lead to reduced profits.
- For most short term traders, e.g., for a day trader, Hedging is a complex strategy to follow.
- If the market is doing well or moving sidewise, then Hedging offers little benefits.
- Trading of options or futures often requires higher account requirements like more capital or balance.
- Hedging is an accurate trading strategy, and successful Hedging requires good trading skills and experience.
Factors to consider in hedging decisions
Some of the factors to consider in hedging decisions are:
- Risk Tolerance: Understand how much financial risk you can handle. If you’re risk-averse, hedging is important.
- Market Volatility: In unstable markets, hedging can protect against sudden drops in value.
- Diversification: Don’t put all your eggs in one basket. Invest in different assets to spread out risk.
- Costs: Hedging strategies can sometimes be expensive. Make sure the cost doesn’t outweigh the potential benefits.
- Expertise: Understanding hedging strategies can be complex. Consider seeking advice from financial advisors.
- Time Horizon: If you’re investing for a long time, you might be able to handle short-term losses without hedging.
Hedging Strategies
There are several hedging strategies, and each one is different. Investors are encouraged not to use just one strategy but different ones for the best results. Below are some of the most basic hedging strategies that investors should consider:
- Diversification– The saying that goes “don’t put all your eggs in one basket” never gets old, and it actually makes sense in finance as well. Diversification occurs when an investor puts his finances into investments that do not move in a uniform direction. Simply put, it is investing in a diversity of assets that are not at all related to each other so that if any one of these drops, the others may rise. For example, a businessman purchases stocks from a hotel, a private hospital, and a chain of malls. If an adverse event impacts the tourism industry where the hotel operates, the other investments won’t be affected because they are not related.
- Arbitrage– The arbitrage strategy is straightforward yet very smart. It involves purchasing a product and selling it instantly in another market for a higher price; thus, making modest but steady profits. The strategy is most generally used in the stock market. Let’s take a simple example of a junior high school student buying a pair of shoes from the outlet store nearby for only Rs. 145 and then selling it to his schoolmate for Rs. 170. The schoolmate is pleased to get a much lower price than the department store, which sells it for Rs. 210.
- Average down– The average down strategy involves buying extra units of a particular product even though the cost or selling price of the product has decreased. Stock investors often make use of this strategy of hedging their investments. If the price of a stock they’ve purchased earlier declines significantly, they buy more shares at a lower price. Then, if the price rises to the point between their two buy prices, the profits from the second buy can offset losses in the first.
- Staying in cash– This strategy is as easy as it sounds. The investor keeps a part of his money in cash, hedging against potential losses in his investments.
Conclusion
When you are investing, you would want to minimise your losses by using various hedging strategies. But make sure you understand the intricacies involved in various hedging strategies too.
Hedging presents a means for traders and investors to alleviate market risk and volatility. It reduces the risk of loss. Market risk and volatility are an essential part of the market, and the main motive of investors is to make profits. But, you are not in the position to control or manipulate markets to safeguard your investments. Hedging might not stop the losses, but it can considerably lessen the effect of negative impacts.
FAQs
Gold can be used to protect oneself from the vagaries of inflation, as it retains its value even though the value of the currency falls. This is premised on the rationale that the price of gold will surge along with the price of other commodities.
Hedge funds or privately owned investment funds are not as regulated as mutual funds or other publicly owned funds.
Hedging can be done for trade in commodities such as gas, oil, metals, dairy, sugar etc. The rationale behind this kind of hedging is to protect oneself against “commodity risk”.
Investors of market-linked instruments hedge their investment by investing into two different instruments with adverse correlation, to minimise the losses, not necessarily mitigate it altogether.
AMCs engage in diversification of portfolios, creating a structure that invests in debt instruments and derivatives and secures the portfolio through options.
