What Is Hedging In Stock Market
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.
Hedging is referred to as buying an asset designed to reduce the risk of losses from another assets. Hedging in finance is a risk management strategy that deals with reducing and eliminating the risk of uncertainties. It helps to restrict losses that may arise due to unknown fluctuations in the price of the investment.
It is a standard practice followed by investors in the stock market to safeguard their investments from losses. This is also done in the following areas:
- Commodities: It includes agricultural products, energy products, metals, etc. The risk associated with these is known as commodity risk.
- Securities: It includes investments in shares, equities, indices, etc. The risks associated with these are known as equity risk or securities risk.
- Currencies: It includes foreign currencies. There are various types of risks associated with it like – currency risk volatility risk, etc.
- Interest rate: It includes lending and borrowing rates. The risks associated with these are known as interest rate risks.
- Weather: It is also one of the areas where hedging is possible.
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.
Different Types of Hedges:
Hedging is broadly divided into three types which will help investors to gain profits by trading different commodities, currencies or securities. These are:
- Forward Contract:It is a non-standardized agreement to buy or sell underlying assets at a determined price on the date agreed by two independent parties involved. Forward contract covers various contracts like forward exchange contracts for currencies, commodities, etc.
- Futures Contract: It is a standardized agreement to buy or sell underlying assets at a determined price on the specific date and standardized quantity agreed by two independent parties involved. A futures contract covers various contracts like commodities, currencies future contracts, etc.
- Money Markets: It is one of the major components of financial markets where short-term lending, borrowing, buying and selling is done with the maturity of one year or less. It covers many forms of financial activities of currencies, money market operations for interest, calls on equities where short-term loans, borrowing, selling and lending happen with a maturity of one year or more.
Advantages of Hedging
- It can be used for locking profit
- Enables traders to survive hard market periods
- It limits losses to a great extent
- As it facilitates investors to invest in various asset classes, therefore, increases liquidity
- It also helps in saving time as the long-term trader is not required to monitor/adjust his portfolio with daily market volatility
- It offers a flexible price mechanism as it requires lower margin outlay
- It gives the trader protection against commodity price changes, inflation, currency exchange rate changes, interest rate changes, etc. on successful hedging
- In hedging using option provides traders an opportunity to practice complex options trading strategies to maximize return
- It helps in increasing liquidity in financial markets
How do investors hedge funds?
There are various strategies opted by AMCs to mitigate losses like:
- Asset Allocation: It is done by diversifying an investor’s portfolio with various asset classes. Like, you can invest 40% in the equities and rest in stable asset classes which helps to balance the investments.
- Structure: It is done by investing a certain portion of the portfolio in debt instruments and the rest in derivatives. Investing in debt provides stability while investing in derivatives protects from various risks.
- Through Options: It includes options of calls and puts of assets, which facilitate to secure your portfolio directly.