Beginners Guide to Hedging Strategy | Espresso

Hedging Strategy Explained

Hedging, in simple terms, can be explained as insurance. When investors hedge, they are financially protecting them from consequences that may arise if the situation turns unfavourable. While this definitely does not mean that the adverse situation is avoided. However, if an unfavourable event occurs, you are properly hedged, which mitigates the impact.

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Hedging is a tool that investors can use to minimise investment risks. It becomes a strategy that you can use by deploying market tactics or financial instruments to lower the risk of adverse changes in the price. As an investor, to make use of the hedging strategy, you must have the necessary skills and expertise so that you can do trading successfully.

Let us get into the details of hedging meaning and types of hedging strategies.

Hedging Meaning

Hedging in the stock market is used to limit the future losses that investors may suffer due to the investments that they have made. A hedging strategy means investing in two distinguishing financial instruments when the correlation is unfavourable.

Hedging strategies are used by retail investors and AMCs with the only purpose of limiting the risks to mitigate the adverse effects of price changes in the market. While hedging techniques cannot fully prevent investors from facing losses, they can alter the extent to which the loss happens.

There are five major areas where hedging is used:

  • Securities market: This includes the market where investments are made in stocks, indices, equities, etc. The risk that is involved in this market is known as equity or securities risk.
  • Interest rate: This is based on borrowing and the rates of lending. The risk that this area carries is known as interest-rate risk.
  • Currency market: This market involves several currencies and carries a risk of market volatility and currency value.
  • Commodity market: This market includes trading in commodities like farming products, metals, etc. The risk that this market carries is called commodity risk.

Thus, there are the areas where investors use hedging strategies.

Types of Hedging Strategies

There are mainly three types of hedging strategies that investors use. These include:

  • Forwards contract: A forward contract is not a standardised contract that involves two independent parties who agree to buy and sell a specific asset at a predetermined price and at a pre-decided date in the future. Forwards contracts are made for different types of assets like commodities, etc.
  • Futures contract: A forward contract is a standardised contract that involves two independent parties who agree to buy and sell a specific asset at a predetermined price and at a pre-decided date in the future. Futures contracts are made for different types of assets like currencies, commodities, etc.
  • Money markets: These types of markets include various financial activities like buying, selling, short-term lending, and borrowing with assets that have a maturity date of one year or less than that.

Top Hedging Techniques that Traders Can Use

Here are the top hedging techniques that traders can use to mitigate their losses:

  • Take a long put position

One of the costliest hedging techniques is a long-put option. Generally, the strike price that is employed is about five to ten per cent below the market price. Although these options are cheaper, they do not provide protection to the portfolio from the first 5 to 10% loss of the index.

  • Collar

This hedging strategy involves purchasing a put option and selling off the call option. When you sell off the call option, you can cover the costs of the put option. The only downside to this is that the upside will also be limited. If the index rises over the strike price of the call option, the call option will then worthlessly expire. However, the gains in the portfolio will offset these losses.

  • Diversification

One of the top hedging strategies that you can use for your long-term portfolio is diversification. By diversifying your portfolio to assets other than equities, the overall risk of the portfolio is minimised. When the market is down, alternative assets tend to suffer less depreciation which is good for your portfolio. Also, these assets can provide you with better returns as time passes. Thus, diversification is one of the top hedging strategies that you can use.

  • Holding cash

When you keep a cash position, you tend to downside risk and mitigate the volatility of the market. This is because the lesser number of risky assets you add to your portfolio, the lesser you lose when the market goes down. But, the trade-off remains that you can get almost negligible to no interest on cash, and as inflation rises, the purchasing power of the cash tends to fall.

Conclusion

This is all you need to know about hedging meaning, types of hedging, and the different hedging strategies that you can use. Hedging offers various advantages to the investors so that they can trade successfully in the market. Risk is one of the unavoidable parts of investing in stock markets, and hedging provides a safety cushion to the investors and traders to protect them from the unpredictable changes in the markets.

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Frequently Asked Questions

Like any other strategy in the market, hedging cannot eliminate all risks. However, hedging can limit the amount of losses that a trader may experience if the market goes down. But if the hedge is a hundred per cent inversely correlated to the asset that is vulnerable, the hedging strategy can be deemed to be one of the best ones.

Here are some of the top benefits of using a hedging strategy:

  1. The first and foremost benefit is that the loss of the investor is minimised due to hedging.
  2. Hedging essentially enhances liquidity as it enables an investor to invest their money across different asset classes and in different markets like the currency market, commodity market, etc.
  3. Hedging also provides a flexible price mechanism as the margin outlay required is very less.

One of the major disadvantages of hedging is that it comes at a cost. So, before you start hedging, it is essential to understand the potential benefits that it brings to you so that you can justify the cost that you are spending on it. In addition, you must remember that hedging is not done to earn profits; it is a method to mitigate any losses that may arise. Thus, the cost of hedging is unavoidable.