Hedging: Meaning, Types, Benefits, Risks and More
Trading and investment are not entirely risk-free. There are various factors that affect the global economy and the market. These factors impact investments which can lead to fluctuations in the returns generated. Now, it is absolutely impossible to get rid of such negative impacts that arise due to various reasons.
The only thing you can do is safeguard your investments as much as you can from the impact of market volatility. Hedging is one of the most widely used strategies that investors across the globe use to keep their investments safe in the event of a market downturn or unfavourable market conditions.
Want to know more about hedging and how it can help investors? Check out the detailed rundown on hedging, its benefits, meaning, types, etc.
What Do You Mean by Hedging?
In simpler terms, hedging can be considered a form of insurance for investors to lessen the losses in the wake of an unfavourable market condition. However, do note that hedging will not nullify or prevent the negative impact of an event entirely. Instead, this strategy will reduce the impact on your portfolio.
Hedging can be seen in various walks of life such as car insurance, life insurance, etc. This technique is used by many to lower the impact and exposure of a negative situation. Hedging requires strategically utilising various market strategies or financial instruments to successfully reduce the impact of unfavourable price movement.
You can use the hedging technique while trading in securities, currencies, commodities, etc.
How Does Hedging Take Place?
In hedging, you are required to use certain financial instruments which are known as derivatives. Options and futures are the two well-known derivatives. With this technique, you can offset any losses in one investment with profits in a certain derivative. It might sound a bit complicated, but in reality, it isn’t.
To have a better understanding of hedging, let’s illustrate with an example. Let’s assume that you own shares of XYZ Company belonging to the mining sector. You intend to own the shares for the long term but are concerned about some losses in the mining sector that would happen in the near future due to any unfavourable macroeconomic factor.
For safeguarding your investment from the impact of falling share prices, you can purchase put options. This will offer you the right to sell shares of XYZ at the chosen strike price. In case the stock’s market price drops beneath the strike price of the contract, your losses are going to be offset by the gains you get via put option.
As an investor, you can hedge against stocks, commodities, currencies and others as there are various types of futures and options contracts available.
What Are the Types of Hedging Tools?
There are three major types of hedging tools which are:
- Futures Contract
This is a standard agreement between two parties for purchasing a particular asset at a predetermined price and at a predetermined date as decided by the two parties. The underlying asset can be currencies, commodities and others.
- Forward Contract
These are agreements (not standardised) between two parties for purchasing a particular asset on a specific date and price fixed by both parties.
What Are the Top Hedging Strategies?
There are various hedging strategies that investors employ for safeguarding their investments from the impact of any probable adverse events. Some of the most commonly used strategies include the following:
These are financial contracts that draw value from underlying security. As an investor, you can choose to invest in stocks, indices, commodities, and others. The gain that your derivative security would be making is going to help you in offsetting any probable loss on single investment.
In arbitrage technique, you as a trader would be buying a financial instrument at a lower price and then selling it off at a much higher price immediately in another market. Although it might not provide better returns, you get consistent profit.
- Spread Hedging
In this hedging technique, you as an investor would buy a put option for an index at a high price. After that, you would sell it at a lower price on the date of expiry. Your hedge would be the difference between the strike prices. This will help to cover you from potential losses in the event of any change in index price.
One of the most commonly known and effective ways to hedge your portfolio is to opt for diversifying your portfolio. Diversifying means investing in various asset classes. This will help you to safeguard your profit, even if you make losses in some trades or assets.
Top Benefits and Risks of Hedging
Some of the major benefits of hedging are as follows:
- The use of derivatives helps to mitigate short-term risk but they are also suitable for long-term investors.
- You can also save much time as when you use a hedging strategy, you need not monitor your investment constantly.
- Investors and traders are protected from losses in case of volatility, market downturn or any other negative factor. You get to lower the chances of loss significantly.
However, in addition to the above-mentioned benefits, hedging also comes with certain downsides. These include:
- Investors cannot get complete protection against the impact of unfavourable market situations. Also, the protection that you get from hedging might be minimal as well.
- If you are an investor who follows a buy and hold strategy, then this strategy might not be useful for you.
If you want to enter into trading and investment, you can use above hedging strategies to protect your portfolio from the negative impact of any unfavourable market condition. This will also enable you to increase the chances of profit.
Frequently Asked Questions
Is hedging illegal?
No, hedging is not entirely illegal; only certain types of hedging are illegal. Hedging is allowed in India, the US and many other countries. However, in the US, hedging in forex is considered illegal.
What does de-hedging mean?
De-hedging refers to closing out a current hedge position. You can do this, if you feel that you no longer need a hedge or in case the cost involved with hedging is too high for you.
What are hedging tools?
Any financial product which allows traders or investors to lower the risk in any asset class is called a hedging instrument. These usually include shares, cash, forex, indices and others.
How much does hedging cost?
Options and futures are used in hedging strategies for lowering the chances of loss. But these contracts sell at a specific premium. The premium amount depends on various factors such as volatility, price of stock, etc.