Beginner's Guide: What is hedging? How it works for investors

Highlights

  • Investors deploy the strategy of hedging to shield themselves against risks in financial assets.
  • Hedging reduces potential loss but doesn’t maximise potential gains.
  • The investment strategy generally involves financial instruments known as derivatives.

Hedging is a popular investment strategy which is employed to limit risks in financial assets. The risk management strategy also typically results in lowering potential profits. Thus, hedging reduces potential loss but doesn’t maximise potential gains.

Investors generally reduce their potential profits if the investment he is hedging against makes money. But, if it loses money and the hedge was successful, he will have lowered his loss.

Beginner's Guide: What is hedging? How it works for investors

Hedging generally involves financial instruments known as derivatives. The most commonly used instruments are options and futures. You can develop such trading strategies using these derivates where a loss in one investment is counterbalanced by a gain in a derivative.

Let’s understand using an example how hedging can protect you against risks.

Suppose you purchases a stock with hope that it’s price would surge in the coming days. However, you still want to protect your investment against the loss in case the price falls. In such a case, the investor can employ a put option to hedge that risk. He can buy the right to sell the share at the same price for a small fee. Thus, he could now exercise put option if the stock price falls and get back the invested sum, minus the fee.

Hedging, derivatives, options, forwards

Image Source: Hedging reduces potential loss and doesn’t maximise potential gains.© Gajus | Megapixl.com

Oil firms are known to hedge against the price of oil while an international mutual fund may hedge against fluctuations in foreign exchange rates.

Another popular hedging strategy is diversification. Investors can own assets that don’t surge and decline at the time in their investment portfolio. Investors generally buy bonds to counterbalance the risk in stocks. Generally, bond value increases when the stock price falls. However, this is true only in case of government or high-grade corporate bonds. Investors should maintain safe distance from junk debt.

Disadvantages of hedging

  • Hedging always comes with a cost which can't be avoided.
  • Also, hedging a portfolio can easily go off track. It is not always easy to achieve a perfect hedge in reality. It is important for investors to properly understand the science of hedging and how it works.

 Bottom Line

It is critical to have a basic understanding of hedging which can help you analyse your investments. Advancing your understanding of the hedging market will always help you be a better investor.

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