Investors often use hedging strategies to mitigate potential losses in the event of a sudden price decline of an asset in their portfolio. By using hedging strategies, you can reduce uncertainty and limit losses without significantly affecting the potential return rate.
Typically, investors buy securities that are inversely correlated to a vulnerable asset in their portfolio. These securities should move in the opposite direction, acting as a hedge against any losses if the vulnerable asset's price moves in the opposite direction. Also, some investors use financial instruments like derivatives to restrict their losses to a set amount.
Buying opposing stocks to secure profits, getting insurance against assets, and offsetting losses using options or futures are all examples of hedging.
What is hedging?
Hedging is an investment strategy that helps investors limit their losses in the market. It acts like insurance for vulnerable stocks by making another investment to safeguard your portfolio.
For example, just as you purchase car insurance to protect your car or asset from damage, in hedging, you can invest in an asset that opposes your vulnerable stock to protect it from losses. This way, if your vulnerable stock plummets due to any fluctuations, your second investment can rise, balancing your portfolio and restricting your overall losses.
There are other hedging strategies and methods; you can select your preferred method based on what works best for your portfolio and financial goals.
Hedging strategies are popularly employed not only by individual investors but also by fund management and portfolio companies to safeguard their funds and their client investments.
Also read: Asset allocation
Different types of hedging strategies
Hedging strategies are not just limited to the share market. They can also be moulded and applied to other markets, such as the commodity market, and investment formats, such as securities. Here, we will discuss three types of hedging strategies that investors use most often to limit their losses.
Diversification
Diversification is a must when it comes to investing. The idea is to spread your investments across different sectors so that if one sector experiences a decline, you have other sectors that could perform well and even out the losses. The more diversified your portfolio is, the better your chances of reducing risks. It is like the saying, "Don't put all your eggs in one basket."
Average down
Average down is a common strategy in which investors purchase more of a falling stock than selling off their existing stocks. This is done to offset their losses from the first buy and to make a profit from the second buy when the price goes back to its steady rate or increases.
Arbitrage
Arbitrage is a strategy that involves immediately selling a stock at a higher price after buying it in another market. This is a clever hedging strategy, as it allows you to make quick profits, even if they are smaller in value. This strategy is more about making money than planning long-term investment undertakings.
There are three types of hedging, and depending on the type, you can choose one of the hedging strategies mentioned above.
- Futures contract - This is a contract between two or more standard parties for the purchase and sale of an asset at a specified price, on a specified date in the future.
- Forward contract - This is a contract for an investment in or a sale of an asset on a specified date at a specified price. For example, a forward exchange contract for currencies or commodities is a type of forward contract.
- Money markets - These are for selling, short-term buying, lending, or even borrowing that takes place with a maturity of one year or less.
How do traders make hedge investments?
There are three popular ways for traders to make hedge investments:
- Asset allocations: A diversified portfolio allows an investor to include different asset classes. This is a straightforward method of making hedge investments; all you need to do is broaden your assets.
- Via options: The right to trade an asset at a fixed price with a fixed maturity or expiry is called an option. Buying is a call option, while selling is a put option. You must, however, hold a long position in the company to utilise an option.
- Debt and derivatives: An investor can diversify their portfolio by making different investments in debt funds and derivatives. Investing in debt funds gives security to your portfolio. It is low-risk and perfect for diversification. Derivatives also safeguard you from risks and help you hedge positions.
The most direct way to engage in hedge investments is by evaluating your portfolio and understanding which investments seem risky and prone to a fall in the current geopolitical scenario. Diversifying your portfolio based on this analysis can help you plan your hedging strategies well and maximise profits.
Perks of Hedging
There are several advantages to adopting hedging strategies:
- Hedging helps you cut losses and maximise profits by strategising your portfolio and investments.
- Hedging provides a flexible cost structure because it requires a significantly lower margin outlay.
- It allows an investor to invest in multiple asset classes, which in turn enhances liquidity.
Also read: Capital asset pricing
Conclusion
Hedging offers investors an opportunity to strategise and safeguard their investments. It provides them with an opportunity to minimise losses and balance out their portfolios. Several hedging strategies, such as the ones suggested above, can help you navigate this volatile market and maximise profits.
