What is hedging? Who uses it, and what for? - Brown Surfing

What is hedging? Who uses it, and what for?

Posted on: December 9th, 2022
By: Efrain Lemus

Hedging is a term that is often heard when people are discussing the stock market or other financial investments, but what does it actually mean? 

Hedging is a way to minimize losses or protect profits from one asset by purchasing or selling another. 

Individual investors commonly hedge for two reasons:

Over-concentration: You own multiple stocks in one company, so you want to protect yourself.

Tax implications: Using hedges to delay the sale of an asset or stock while protecting its value.

But is this trading strategy a good choice for you? Here’s what you need to know about hedging.

Understanding hedging

Hedging is an advanced risk management strategy involving buying or selling an investment to help reduce the risk of losing an existing position. It is the practice of opening several positions at the same time to protect your portfolio from uncertainty or volatility within the financial markets. 

The idea behind hedging is that you don’t have to put all of your eggs in one basket—you want to spread out your investments so that if one fails, the others will cushion any losses. By doing this, you are mitigating some risks associated with investing in volatile markets or specific stocks or funds. 

What investments are used to hedge?

Hedging can involve many strategies but is most frequently done with options, futures, swaps, and other derivatives. Options are one of the most common investments that individual investors use to hedge. It is important to note that trading options and contracts require the execution of a separate option/futures trading agreement.

Who uses a hedging strategy?

Anyone with a large amount of money or a portfolio can use a hedging strategy.

Hedging isn’t just for those new to investing—even experienced portfolio managers use hedging strategies as part of their overall investment plan. This is especially true when markets become more volatile due to events such as political changes or economic shifts. 

Retail traders commonly use hedging strategies with good knowledge of the financial markets and who can predict economic changes. Professional investors often use hedging strategies as part of their portfolio management plan to minimize risk while achieving their desired returns.  

Examples of Hedging Strategies

Hedging strategies vary depending on the financial market and asset you are looking to trade. Investors are encouraged to use not just one strategy but different ones for the best results. Here are some of the most popular approaches that investors use in trading:

1. Diversification

Diversification is when an investor puts his money into assets that don’t move in a uniform direction. Simply put, it involves investing in various assets to spread out risk. For example, rather than investing all of your savings in one stock, you could invest in a diverse portfolio of bonds, stocks, and other securities. This way, if one investment loses value, the others may offset the loss.

For example, if you invest in stocks, consider investing in bonds or real estate. This way, if the stock market crashes, you will still have other investments to fall back on. 

2. Average down

The average down strategy involves buying more units of a specific product even though the selling price of the product has declined. 

This technique involves buying additional security units after the price has fallen to lower the average cost per unit. For instance, suppose you purchased 100 shares of ABC stock at $50 per share. The price then falls to $40 per share. Rather than selling your ABC shares at a loss, you may choose to buy an additional 100 shares at $40 each, bringing your total position to 200 shares. Your average share cost would be $45, which is lower than your original purchase price.

3. Arbitrage

Arbitrage hedging is a strategy that seeks to capitalize on price differences in different markets for the same security. The strategy involves buying the security in one market and selling it simultaneously in another market where the price is higher. 

For example, if shares of Company A are trading at $50 in market 1 and $55 in market 2, an investor could buy shares in market 1 and sell them immediately in market 2, pocketing a $5 per share profit.  

Perks of hedging

  • It helps to lock in profit and limit losses.
  • Hedging enhances liquidity as it allows investors to invest in different asset classes.
  • It protects against numerous changes, such as inflation, interest, currency exchange rates, etc.
  • An efficient way to diversify your trading portfolio with different asset classes.
  • Helps to boost liquidity within the financial markets.
  • Requires a lower margin outlay and offers a flexible price mechanism.

Risks of hedging

Despite its benefits, hedging can be a double-edged sword, especially if the hedging investment deteriorates or negates the benefit of the underlying value increase. 

There are several reasons why hedging may not be the best option for individual investors:

Complexity:

Hedging generally involves advanced investment instruments (as opposed to traditional investments like stocks and bonds). In order to fully utilize hedging, you have to understand the hedging instrument.

Suitability:

Long-term investors may need clarification on hedging. Let’s say you plan to own a stock for a long time (over a year). After a few months, you believe the stock may be at risk of loss in the short term. In the long run, hedging risk exposure may not make sense due to the costs involved.

Effectiveness:

Hedging is only effective if the hedger implements it as intended. Consider the example of an investor who purchases a diversified mutual fund. If you believe that certain components of the fund are at risk of loss, you may need to be able to hedge only those components.

Hedging and the everyday investor

No matter what kind of investor you are—beginner or professional—hedging can effectively manage risk while still achieving desired returns on your investments. By diversifying your investments and balancing out potential gains and losses, you can protect yourself against unexpected market movements that could cause serious damage to your portfolio. 

If you decide to create a hedge, be sure you understand the mechanics of it, including (when applicable) the strike price and how much you’ll pay or earn in premiums.

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