Hedging – Meaning, Strategies, Types, How to use, Advantages & moreLast Updated Date: May 12, 2022
Hedging Strategy in stock market is one of the major risk management technique, helps the investors to mitigate loss.
For instance, it offset the investment losses by initiating buying and selling the related asset.
- The reduction in risk leads to a reduction in profits as it creates a balanced situation.
- Hedging strategies include derivatives, e.g., Options and Futures Contracts.
- Hedging doesn’t ensure the profitability of the investor but protects from the risk associated with investments.
- The Hedging funds managers can earn huge for their smart decision, but they lose nothing from their savings if they incur a loss.
- The hedging strategy isn’t free; it comes at some cost.
What is Hedging?
You’re already familiar with the word ‘Hedging’ since we use it in our day-to-day lives.
It can be referred to all the processes that we use to protect our lives. e.g., parents getting us vaccinated that safeguard our lives from certain diseases, we buy insurance to stay prepared to handle the future risks related to accidents or health crises, etc.
In both examples, you perhaps find one thing similar. Vaccination and buying insurance, doesn’t grant you full protection for the future, but both these things assure you that the upcoming risk will be minimal.
The same scenario is implied in the Hedging strategy. Investors always remain unsure about the upcoming downturn or upturn in the market.
But here, the hedging strategy provides them with full support by protecting their investments. It includes the process of buying an asset to mitigate the risk of losses associated with other assets.
In short, you can pronounce it as a risk management strategy in finance. It either eliminates or reduces the risk of uncertainties in the market.
Since the risk of loss in the market is usual as prices fluctuate over time. It’s a standard practice that safeguards the investments of the investors in the stock market.
You can find Hedging strategy being widely employed in the following risky areas:
Securities or Stocks: It refers to the investments made by investors in equities, shares, indices, etc. Similarly, the risk related to these securities will be identified as security or equity risk.
Commodities: It includes energy products, metals, farming products or agricultural products, etc. In the commodity market, the probabilities of risks stay high, identified as commodity risks.
Interest Rate: This area consists of interest rate risk, e.g., risk in lending rates or borrowing rates, and remains high.
Weather: It’s also denoted as an area where the hedging strategy is employed if the weather influences or triggers risk in the market.
Currencies: Currency risks mainly include risk related to foreign currencies. Such as currency volatility risk etc.
So these are some of the common risks fluently handled by hedging strategies. Let’s dive into the article’s depth and discover more about the right sides of Hedging strategies.
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About Hedging Strategy and its use to mitigate losses
Risk and returns always go hand-in-hand, even though it’s general life or stock market.
There’s nothing wrong in expecting high returns, but the risk associated throughout the way to the high-returns can’t be overlooked. The modest miscalculation can lead to a considerable loss.
That’s why experts bring the ‘Hedging’ strategy into action. If you’re new in the stock market, then the word ‘Hedging’ perhaps sounds a bit strange or unrelated.
Still, it’s an effective method that mitigates the risk of loss in the stock market, primarily when many fluctuations occur in the market.
Therefore, if you seek profitability and sustainability in the share market for a long time, it becomes essential for you to raise your familiarity in every financial term that can help you become rich after a few perfect calculations.
You should know about the term ‘Hedging.’ So, without waiting more, let’s head to the proper definition, defining this powerful term carrying the potential to make you the best stock market player.
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Types of Hedging Strategies
On the big picture, hedging strategies are used through the following types:
Forward contract refers to the agreement between two parties willing to buy or sell assets. The agreement includes specified prices, dates of selling, or buying assets.
In the commodities and currency market, the forward contract is widely used.
It’s a kind of standard contract or agreement made between two parties willing to buy or sell assets.
The agreement includes agreed terms on price and quantity of the assets purchased or sold on a particular date.
The future contract covers the following types of contracts, such as – currencies, commodities, etc.
It’s one of the well-noticeable parts of the financial market, in which the short term buying, selling, lending, or borrowing happens.
The money market maturity period lasts for less than one year. On the other hand, if we talk about the areas that the money market covers.
It includes money market operations for currencies and interest, calls on equities, especially where short-term borrowing, lending, selling, and loans happen, including the maturity period of less than one year.
How do Hedging work in different Asset Classes?
First, you need to acknowledge the words you’ll be using while understanding the hedging strategies.
It’s a derivate of Hedging providing the traders the right but not the obligation on them as they are free to buy or sell an asset at a certain quantity, at a fixed price (also known as the exercise price).
It only follows a little condition that the trading should be done before the expiration date. The ‘options’ have also split up into the two types- Put (the right to sell) and Call (the right to buy).
It’s a kind of contractual agreement for a futures exchange to be made on the trading floor, such as when traders want to buy or sell a specific financial instrument, commodity, etc. in the future.
The price of these trading instruments is, however, pre-determined. Now, let’s put light on hedging strategies. Hedging is a kind of balance that facilitates support for any investment.
The contract is the most common form of Hedging, whose value is evaluated based on the original asset.
For instance, if an investor is done buying a particular company’s stocks, expecting these stocks’ prices will incline in the future.
But instead of inclining, the stock’s prices fall significantly, creating a tensed situation for the trader.
However, with the help of Hedging, this situation of loss becomes easy to mitigate. Such as, if an investor is using an option, so he/she can put-off these incidents.
In adverse events, it provides a balanced position to the traders. In certain instances, investors can choose a put option that can help them draw profits despite the decline in stock price.
How should you use Hedging Strategies or Techniques?
Like any other trading strategies, Hedging strategies can be employed numerously.
In the below types of hedging strategies, you’ll obtain a unique insight into how traders should use Hedging differently to derive the desired results.
Let’s explore these types, stated below-
A smart investor never puts his entire investment on a single asset because its performance is unpredictable; that’s why you should play a safe game.
Similarly, the diversification guides the investor to put his/her investments in multiple assets, and an investor reaps the benefits of these assets that aren’t related to each other.
For instance, if any particular asset indicates loss to the investor, the probabilities are high that other assets may end up providing profits to the investor.
For instance, a businessman is initiating investment and purchasing stocks from a hotel, malls, and private hospital.
Due to recent events, the tourism sector incurred losses that negatively impacted that businessman’s investment in hotels.
However, this loss will not affect the financial position of that businessman because his other investment platforms will be generating profits for him.
Arbitrage is one of the simple yet easy-to-understand strategies. The strategy includes instant trading, such as buying the product and selling it to another market immediately at a higher price.
In this way, a trader derives small but regular profits. Most of the small traders use this stock market strategy.
Let’s understand the Arbitrage strategy through a simple example- if a student is buying a pair of shoes from the local store for only Rs.300, but later sell it to his friends for Rs.350.
The friend is happy because he has bought these pairs of shoes at a lower price. After all, in big showrooms, these shoes are on sale at a high price. In short, it satisfies both buyer and seller.
The average down strategy is also a widely used hedging strategy, which includes buying a particular product in an extensive amount in the situation when the selling price or the cost of that particular product has declined over time.
Again, if the price of this purchased product declines in the future, you’ll end up buying them more.
In the future, if the price of these products inclines even though to the points between these two buy prices, the probabilities are high that the trader will earn profit from the second purchase units of products that may offset the losses incurred in the first buy.
Staying in Cash
The name is simply defining the situation of using this strategy. In brief, while investing, an investor holds some money in cash, and when required, he uses it against potential losses to sustain balance in the financial position.
Hedges and Hedge Funds
Hedge-funds use multiple derivatives for investments in Hedging. The involved funds in Hedging are generally privately-owned funds for investment.
For instance, these aren’t mutual funds regulated by the government, unlike those mutual funds run by public corporations.
The managers of hedge-funds earn a small percentage of the returns. If there is no return or loss of money, these managers don’t receive any percentage.
Similarly, it makes Hedge Funds quite popular among investors who dislike this particular shortcoming of mutual funds that demands fees for such things.
The overall compensation structure of the hedge fund is excellent. The managers of hedge fund, if they make a sound investment decision, they earn profits.
If they make a terrible decision on investments, they perhaps lose their jobs. However, throughout the process, managers keep a portion of earned wages.
Similarly, if they smartly bet large, then they are likely to make tons of money. On the other hand, even though the manager loses, they’ll not lose their personal money.
But it creates a precarious situation for the investors because they may be likely to lose the entire money they have saved throughout their life.
How do investors Hedge Funds?
There are plenty of strategies that investors use to mitigate losses, such as-
Asset Allocation: Asset allocations are done explicitly by diversifying an investor’s portfolio using plenty of asset classes.
For example, an investor can invest 40% in becoming a member of a company’s equity share, and the rest amount he can invest in stable asset classes.
In this way, an investor balances his investments.
Structure: It includes when an investor invests the portfolio’s particular option in the debt instrument and the derivatives’ specific portion.
The debt investment facilitates stability to the portfolio, whereas the derivatives investments will protect the investors from the futuristic risks.
Through Options: This, through options strategy, includes both options’ types. e.g., “Calls” and “Puts” of the assets. It helps the investor to secure his portfolio effectively.
Advantages of Hedging
Here are the various advantages or benefits of Hedging –
- A trader can use a hedging strategy to lock the profit.
- In instances where most traders fail to survive in the market, hedging strategy provides support.
- It limits the loss that a trader was likely to bear.
- It enables investors to invest in other asset classes that boost liquidity.
- For a long-term trader, hedging strategy is fruitful, providing them with rid of monitoring and adjusting portfolio, ensuring saving time.
- Provides trader a flexible price mechanism
- A trader feels safe, even though lots of swings are occurring in the market, such as inflation, currency rate changes, price changes, interest rate changes, and so on.
- Traders can exercise more trading strategies, which ensures the maximization of return on the trader’s end.
- In the financial market, hedging strategies increase liquidity.
Disadvantages of Hedging
It’s essential to mention that every hedging strategy isn’t free. That’s why you must know about the cost associated with the Hedging strategy you’re going to use.
Before you come across the decision to ‘taking help from Hedging,’ make a clear pattern of your requirements and then decide if you are ready to pay the expenses associated with Hedging’s potential benefits.
But bear one thing in mind, the Hedging strategy doesn’t promise you profits; it just a way that protects investors from incurring losses.
Altogether, Hedging is undoubtedly a great practice to employ in the trading environment. Still, one must exercise the strategies thoroughly or seek help from experts.
Conclusion – Hedging & Hedging Strategies
In the final word-wrap up, we’ll again recall the important line ‘risk and return go hand-in-hand.’ But in most instances, risk can become profitable if considered smartly.
Still, whether you’re just a beginner or professional investor, basic knowledge in financial strategies has always been requisite.
Similarly, if you employ effectively, hedging strategies can protect you from losses. However, learning hedging strategies also empowers your vision of the understanding market environment.
Ultimately you become a smart investor.
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