It doesn't matter what your investment type is; hedging is a practice every investor should know about. And you cannot argue that if you’re focusing on portfolio appreciation, you have to look at portfolio protection equally seriously. It is not an esoteric financial requirement. It is for everyone, including those who have just started as an investor.
What is Hedging?
Hedging is like insurance for any negative event that might occur in the market that could damage your investments. We’re not saying that hedging will prevent the negative event. But if you’re properly hedged when it does happen, the impact of the event will be reduced. Hedging is happening all around us. For example, if you buy insurance for your car, you’re hedging against thefts, accidental damages or any other unforeseen disasters.
Many portfolio managers, investors, and small and large corporations use hedging to lessen their exposure to risks. But unlike the car example, hedging in financial markets is more complicated.
So if we have to answer the questions – what is hedging, hedging against investment risk means tactically using tools in the market to offset the risk of any hostile price movements. In other words, investors hedge one investment by making another. To hedge you would invest in two securities with negative correlations and you have to pay for this type of insurance in one form or another.
As investors, we all want to trade in a market where profit potentials are limitless and risk free. But hedging is not a tool used to create this utopic environment. A reduction in risk means a reduction in potential profits. So we can say that hedging is a technique not for making money but to reduce potential losses.
So if you’re still unclear about what is hedging, here’s a simple definition.
If the investment you are hedging against makes money, you will have normally reduced the profit that you could have made. But if the investment loses money, your hedge, if successful, will reduce that loss.
What is hedging and what are the different hedging techniques?
Hedging techniques deploy complicated instruments like derivatives, the two most common of which are options and futures.
Let's see how this works with an example. Say you own shares of company X. Although you believe in this company for the long run, you are a little worried about some short-term losses in the industry. To protect yourself from a fall in CTC you can buy a put option (a derivative) on the company, which gives you the right to sell CTC at a specific price. This strategy is known as a married put. If your stock price tumbles below the strike price, these losses will be offset by gains in the put option.
The other classic hedging example involves a company that depends on a certain commodity. Let's say Company X is worried about the instability in the price of its commodity. This company would be in trouble if the price of the commodity skyrocketed, as this would eat into profit margins severely. To hedge against the uncertainty of the commodity’s prices, Company X can enter into a futures contract, which allows the company to buy the said commodity at a specific price at a set date in the future. Now Company X can budget without worrying about the fluctuating commodity.
What is hedging’s downside?
For hedging in finance every hedge has a cost, so before you decide to use hedging, you must ask yourself if the benefits received from it justify the expense. Remember, the goal of hedging isn't to make money but to protect from losses.
What is hedging in Forex?
When a currency trader enters into a trade with the intent of protecting an existing or anticipated position from an unwanted move in the foreign currency exchange rates, they can be said to have entered into a forex hedge. By utilizing a forex hedge properly, a trader that is long a foreign currency pair, can protect themselves from downside risk; while the trader that is short a foreign currency pair, can protect against upside risk.
The primary methods of hedging currency trades for the retail forex trader is through
Foreign currency options
Spot contracts are essentially the regular type of trade that is made by a retail forex trader. Because spot contracts have a very short-term delivery date (two days), they are not the most effective currency-hedging vehicles. Regular spot contracts are usually the reason that a hedge is needed, rather than used as the hedge itself.