Although “hedging” can make it sound like something your gardening-obsessed neighbor is doing, it refers to a valuable investment strategy that all investors should be aware of. Hedging in the stock market is a technique to protect your portfolio, sometimes just as important as portfolio development.
Hedging is generally portrayed in broader terms than actual explanations. It is not, nonetheless, an unusual term. Even if you are just starting off as an investor, understanding what hedging is and how it functions can be helpful.
What is Hedging?
Hedging is best understood by considering it to be a type of insurance. When someone chooses to hedge, they are protecting their finances against the consequences of a bad event. This does not guarantee that all bad things won’t happen. However, the impact of a terrible incident is reduced if you have enough insurance coverage.
Hedging happens practically everywhere in reality. For example, buying a homeowner’s insurance can protect you against fires, break-ins, and other unexpected events. Portfolio managers, individual investors, and companies all employ these strategies to minimize their exposure to certain risks. However, it is more complex in the financial markets than just paying a health insurer a yearly fee for coverage.
Using financial instruments or market strategies systematically to balance the risk of any unfavorable price swings is known as hedging against investment risk. To put it another way, investors use a trade in another investment to protect one of the investments. You must execute opposing transactions in assets with low correlations to hedge. Of course, you will still need to pay for this insurance somehow.
For example, if you hold shares of XYZ corporation, you can purchase a put option to hedge against sharp declines in the value of your stock. However, you must pay the option’s premium in order to obtain it. Reducing risk always reduces the likelihood of profit. Therefore, hedging is primarily a strategy designed to minimize prospective losses. In the event that the investment you are hedging against is profitable, you have typically also decreased your potential profit. If your hedge was effective and the investment loses money, you will have minimized your loss.
Hedging Strategies
The following categories are used to classify hedging strategies:
Forwards Contract
This is a contract between two parties to buy or sell assets at a specific price on a given date. Contracts like forwarding exchange contracts for commodities and currencies fall under this category.
Futures Contract
This is a typical contract between two parties for the buying and selling of assets at a certain price and quantity on a given date. This includes several contracts, including currency futures contracts.
Money Markets
These are the marketplaces where transactions with maturities of less than a year for short-term purchases, sales, loans, and borrowing take place. This covers a range of contracts, including covered calls on stocks, interest-paying money market transactions, and currency.
Disadvantages of Hedging
Each hedging strategy has a cost attached to it. Therefore, you should consider if the possible advantages exceed the cost before deciding to employ hedging. Remember that the goal is to protect against losses rather than to generate income. It is impossible to avoid paying for a hedge, whether it is the price of an option or losing earnings from being on the wrong side of a futures contract.
Although it’s tempting to contrast insurance and hedging, insurance is far more exact. When you have insurance, your loss is fully covered. A portfolio’s hedging is not an exact science. Things may go wrong very easily. Although risk managers always strive for the ideal hedge, implementing it is incredibly challenging.
Takeaways
- Hedging is best understood by considering it to be a type of insurance.
- Forwards & Futures Contracts and Money Markets are used to classify hedging strategies.
- Investors use a trade in another investment to protect one of the investments.
- Hedging is primarily a strategy designed to minimize prospective losses.
