Hedging Definition

The reality of investing is that there is always some risk involved. Still, this does not mean that investors should voluntarily accept all the risks they are exposed to. This is where hedging comes in. Hedging is the process of opening a trade position in the market to offset the risk of another investment or trade position. Essentially, hedging is a strategy to reduce and control exposure to investment risk. There are numerous types of risks that investors are usually exposed to.

Types of Risk

The main risk investors are exposed to is market risk. This is the risk of an investment decreasing in value because of events or developments that impact the entire market. Common market risks include currency risk, interest rate risk, as well as open position risk.

  • Currency risk implies that your investment is vulnerable to losses because of changes in foreign exchange rates in the market. For instance, if a European investor holds US stocks and the US dollar loses its value, it will mean that his shares are worth less in euros.
  • Interest rate risk implies that changes in interest rates will impact your investment. For instance, bonds typically have an inverse relationship with interest rates, so when interest rates rise, bond values fall, and vice versa.
  • Open position risk is the more straightforward type of market risk. It implies the potential of your investment losing value because of price fluctuations in the market.

Other types of risk include inflation risk and concentration risk.

  • Inflation risk is the loss of purchasing power because your investments are not keeping up with inflation. Investors typically hedge against inflation by buying assets, such as gold or real estate that tend to outperform inflation over time.
  • Concentration risk is the risk of loss due to apportioning a considerable percentage of your capital to one or a few types of investments. Investors usually hedge against concentration risk by diversifying their investments so that risks are spread across different asset types or industries.

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Hedging against market risk can be done by using different investment vehicles such as trading derivative contracts. For instance, if you have Apple shares and there is a risk that prices may fall in the medium term, you can hedge by buying put contracts on the stock in the options market.

In essence, hedging is akin to taking an insurance policy against risks that may impact your investments. As insurance, the purpose of hedging is not to eliminate risk but to reduce the impact of any event that would otherwise have led to a devastating loss of investing capital.

Still, hedging is not as straightforward as insurance. There are different ways to hedge against investment risk, and some strategies only apply to specific types of investments, such as currency hedging. Not all assets have to be hedged, but when you take in more risk than you are comfortable with, implementing a hedging strategy can help you determine the level of risk exposure that is acceptable to you.

Pros and Cons of Hedging

The most significant advantage of hedging is that it helps control investment risks, regardless of market conditions. By hedging, investors can limit the maximum loss they can incur with their various investments in the market. Investors of all kinds face different risks, which different hedging strategies can mitigate. For instance, airline companies often hedge the future cost of fuel to protect themselves against abnormal price spikes in the market.

Hedging is also a time-saving strategy. Investors do not have to alter their portfolio composition or make any other investment decisions based on changes in the market. This also means that investors can ride out challenging periods in the market without any need to make drastic decisions.

Hedging can also have several strategic benefits for companies. The strategy can help companies lock in profits for the goods they produce. For instance, commodity producers use the futures market to hedge open positions and lock profits by agreeing to fixed prices for future production. In this way, they are insulated from any potential drop in prices for the underlying products.

Hedging is also known to improve the ability of a company to raise capital. Companies that hedge have attractive risk profiles and score highly in performance metrics such as the Sharpe ratio and Treynor ratio. This makes it easy for them to attract debt holders who will be confident in their ability to repay them sustainably. Companies that hedge are also able to enter new markets with ease. By hedging forex, they can hedge effectively against currency risk and expand even to countries with high volatility in their local currencies.

But there are also downsides to hedging. First, it can be very costly to remain neutral in the market. Costs are associated with every hedging strategy, which can eat up your potential profits. Also, hedging is not a strategy to earn profits but rather to limit risks. Risk and reward go hand in hand in investing, and the potential reward is reduced by reducing risk.

Hedging can also be a complex strategy to implement successfully. It requires precise knowledge and techniques to execute some hedging strategies to your benefit. For instance, you must understand different markets, such as options and futures, to successfully hedge against risks in the equities market.

How to Hedge – Hedging Strategies

There are different types of hedging, and some can only be applied in specific scenarios. Here are some of the more common hedging strategies:

Diversification

Diversification is a strategy that seeks to reduce the risk of concentration in a portfolio. It involves investing in several unrelated assets such that when some reduce in value, others rise. For instance, you can have a portfolio mix that includes bonds, stocks, commodities, and cryptocurrencies. If stocks are in a meltdown, the returns realized by cryptocurrencies could offset the loss in the equities market.

Buying Put Options

Put options are contracts that give investors the right but not the obligation to sell a certain amount of an underlying asset within a specified timeframe. Put option contracts increase in value as the price of an underlying asset decreases. This makes buying put options an excellent way to hedge against falling prices of various securities. For instance, if you own Tesla shares and the price has spiked higher, you can buy put options to protect yourself against the potential decrease in the stock price. The same principle can be applied to the reverse scenario where the investor buys a Call option to offset the risks associated with a short position in a specific asset.

Futures Contracts

Companies usually enter into futures contracts to lock in specific prices for their products or raw materials in the foreseeable future. For instance, a food processing company can agree on a particular price with farmers when they harvest their produce. In this way, they can predict their costs effectively. Futures contracts can be extended to other financial assets, such as stocks and bonds.

Average Down

Averaging down is a strategy that involves buying more of an asset as its price continues to decline. This decreases the overall price of an investment, meaning a slight increase in the price has the potential of offsetting losses of the initial position. For instance, if you bought a stock at $100, and the price declines to $50. If you buy the same amount of the stock at that lower price, your effective overall purchase price is $75. If the stock’s price rises to $80, you are already in profit.

Stay in Cash

This is as straightforward as it sounds. Having some of your money in cash can be an effective hedging strategy because you are not exposed to any investment risks. This strategy can be advantageous during downturn periods when most investments lose value.

Final Word

Hedging allows investors to limit their risk exposure in the markets. While investments are made to make profits, the risks involved can sometimes lead to devastating losses. Therefore, implementing hedging strategies is essential when you wish to reduce or control your risk exposure in the market.

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FAQ

  • What Does Hedge Mean In Trading?

    Hedging is the process of opening a trade position that seeks to offset the risk posed by another open position in the market.

  • How Do You Hedge A Trade?

    You can hedge a trade by opening opposite trades on correlated assets. For instance, if GBPUSD and EURUSD are positively correlated, you can choose to buy GBPUSD and sell EURUSD. If both assets decline in price, the losses made in the GBPUSD position will be offset by the profits made in the EURUSD position.

** Disclaimer –While due research has been undertaken to compile the above content, it remains an informational and educational piece only. None of the content provided constitutes any form of investment advice.