Hedging is a crucial financial strategy that helps investors and traders reduce their exposure to different risks. In a hedge, investors try to offset the risk associated with a particular investment by taking a position opposite to it. Essentially, they aim to balance potential losses in one investment with gains in another.
In this article, we will understand what is hedging, hedge’s meaning, how it works, its downsides, and some widely used techniques of hedging.
What is a hedge?
Hedging is a risk management strategy employed to offset potential losses in investments by taking an opposing position in a related asset. This counterbalancing position aims to minimize the impact of adverse price movements in the primary investment. While hedging reduces risk, it also typically limits potential profits, as gains in the primary investment may be offset by losses in the hedging position.
Hedging helps mitigate risks by essentially creating an insurance policy against unexpected losses. By taking an opposite position to the primary investment, traders can limit their downside exposure. For instance, if a trader is long on a stock and concerned about a potential price decline, they might hedge by shorting stock options or buying put options. This strategy ensures that even if the stock price falls significantly, the losses from the primary position can be partially or fully offset by gains from the hedging instrument. Hedging is a valuable tool for investors and traders across all asset classes, allowing them to manage risk more effectively and pursue their investment objectives with greater confidence.
How does hedging work?
Hedging your investments is similar to having an insurance plan for yourself or wearing a seat belt while driving. If, in an unfortunate situation, you end up in an accident, the seatbelt will reduce the risk of you getting seriously injured, but won’t prevent the accident.
Similarly, hedging does not eliminate the chances of you making a loss on an investment, but it does reduce the impact the loss can have on your financials when the markets are in a state of flux.
Another scenario could involve you investing in some of the best blue-chip IT companies because your research says that the sector is poised to do well in the next few quarters. But to hedge this investment, you might also invest in healthcare or consumer staples businesses, just in case your earlier investment does not perform up to the mark.
Perfect hedge meaning
A perfect hedge is a theoretical investment strategy that aims to completely eliminate risk. However, in reality, perfect hedges are unattainable due to the associated costs.
In practical scenarios, investors typically hedge only a portion of their portfolio or implement hedging strategies for a limited duration.
Hedging practical applicability
Hedging, typically implemented through derivative instruments like futures, forwards, options, or swaps, aims to mitigate risk associated with underlying assets such as stocks, bonds, commodities, or indices. The derivative's value is intrinsically linked to the underlying asset, allowing it to offset potential losses from adverse price movements.
For instance, consider an investor buying 10 shares of Reliance at Rs 10 per share while simultaneously purchasing put options on 10 shares with a strike price of Rs 8 and a premium of Re 1, expiring in a year. If the stock price rises to Rs 15, the investor profits from the stock but incurs a loss on the put option. However, if the stock price plummets to Rs 2, the investor can exercise the put option, limiting their loss to Rs 3 per share instead of the potential Rs 8 per share loss without the hedge.
The cost of a hedge is directly influenced by the likelihood and magnitude of potential losses. Consequently, hedges become more expensive as the risk of adverse price movements increases. By carefully considering the variables involved, investors can structure hedges to suit their specific risk tolerance and investment goals.
The downside of a hedge
Hedging involves a balance between risk and reward. While it helps in reducing potential losses, it also limits the amount of profit you can make. This tradeoff means that while you are protecting yourself from big risks, you are also giving up some of the potential gains you might have achieved without hedging.
Another important thing to note is that hedging does not happen free of cost. In the case of insurance, you have to pay a premium at regular intervals in time to have that extra layer of protection. And if you never need to use the insurance, you will get nothing after the insurance period is over.
In the financial world, hedging works similarly. Financial experts, investors, traders, and money managers apply the practice of hedging to minimise their losses and reduce their exposure to different market risks.
Hedging with derivatives
Derivatives are financial instruments that derive their value from the price of an underlying asset. Some widely used types of derivatives are forwards, futures, and options.
Derivatives derive their usefulness and effectiveness from their delta, also referred to as a hedge ratio. This delta is defined as how much the price of a derivative is expected to change for every change in the price of its underlying asset.
The choice of a hedging strategy and the cost of hedging tools are primarily influenced by the potential downside risk of the underlying asset that the investor wants to protect. As a rule of thumb, the more downside risk of an investment there is, the more cost of hedging will be. As the volatility of an investment increases with time, so does the downside risk associated with it.
Generally, a put option with a higher strike price will cost more but provide better protection against price drops. You can adjust these factors to choose a less expensive option with less protection or a pricier one with more protection, depending on your needs.
Example of hedging
The most widely used way of hedging in the financial world is by using put options. By exercising put options, the investor or holder gets the right but is not obliged to sell the security they are holding at a pre-determined rate and time or anytime before the date expires.
For example, let us assume Mr. A buys 100 shares of a company at the price of Rs. 750 per share. Now, he has the option to hedge this investment by purchasing a put option, which allows him a strike price of Rs. 600, which will expire in the course of a year. By buying this put option, Mr. A now gets the right to sell these 100 shares of the company at the price of Rs. 600 whenever he wishes before the next year.
Now, he will also have to pay a premium for the put option, whose price, let us assume, is Rs. 80 per share, which translates to Rs. 8,000 for 100 shares. Now, if the share starts trading for Rs. 900, Mr. A will not need to exercise his put option and his payment of Rs. 8,000 will not be recovered. However, this does not turn out to be a loss-making deal for him since he has already covered the cost of the put option through his unrealised gains due to the price movement of the share.
However, due to an extreme market fluctuation, if the stock starts trading at Rs. 0, then the following will occur:
- Mr. A exercises the put option and sells the shares for Rs. 600 per share.
- Total amount received from selling = 100 shares × Rs. 600 = Rs. 60,000
Total cost of investment including option:
Total investment + cost of the put option = Rs. 75,000 + Rs. 8,000 = Rs. 83,000
Net loss calculation:
- Total cost (investment + option) = Rs. 83,000
- Amount received from sale = Rs. 60,000
Net loss = Total cost - Amount received = Rs. 83,000 - Rs. 60,000 = Rs. 23,000
Mr. A makes a loss of Rs. 23,000 on this investment. If Mr. A had not bought the put option, he would have ended up losing his entire investment.
Hedging through diversification
Opting for diversification in your portfolio is also considered a good way to hedge your investments.
Let us take the example of Mrs. B, who is bullish on the growth of luxury brands in India and hence decides to invest in them, given their high margins. However, there are a few risks involved with this investment, such as a sudden crash or a recession that ends up eliminating the demand for lavish goods and luxury spending. So, to hedge this investment, Mrs. B will also invest in consumer staples stocks or utility stocks since these categories can withstand recessions and pay good dividends.
However, this strategy requires the investor to make a tradeoff. If people's incomes are on an upward trajectory and the job market is seeing positive growth, then luxury goods will be in demand. Only a few investors at this point would want to invest in countercyclical and boring stocks like staples and utilities. As a result, the prices of these stocks can fall a bit as capital moves to more happening sectors.
But this approach also has a risk. There is no sure-shot way of predicting that if the stock price of luxury goods falls, the hedge in the form of staples and utility will always move in the opposite (upward) direction. A global event like the financial crisis of 2008 can lead to the collapse of all the share prices for a short to medium-term period.
Spread hedging
Investors who are more involved with index funds see a moderate decrease in the price of the index quite commonly but these trends are not predictable. So, the focus of the investor here is to have a hedge for these moderate decline market cycles rather than prepare for the more extreme ones. This is where the spread hedging strategy comes into play.
In this type of strategy, an investor buys a put option, which has a higher strike price and sells a put option, which has a lower strike price, both expiring on the same date. This approach allows the investor to limit potential losses while potentially earning a profit if the price of the underlying asset falls.
Now, depending on the movement of the index, the investor has a certain degree of protection, which is the difference between the two strike prices. However, this is not a comprehensive protection and can only be useful and sufficient during brief periods of market fluctuations.
Hedging and the everyday investor
Investors who are in the market for the long term, like those saving for retirement or planning a college fund for their toddlers, do not necessarily need derivative contracts since they are unaffected by the frequent fluctuations of the market. Long-term investors who buy and hold do not require any protection in the form of hedging.
However, multinational companies and fund houses widely use hedging as a tool. Many investors would be invested in funds handled by such companies. Hence, it is important to have a basic understanding of these concepts and see how hedging is used by large market players to minimise losses and protect the capital of their investors.
Advantages of Hedging
Here are few advantages of hedging-
- Securing profits: Hedging can be employed to lock in existing gains and protect against potential future losses.
- Market resilience: It allows businesses to navigate challenging market conditions by mitigating risks associated with price fluctuations.
- Loss reduction: Hedging significantly reduces the potential for financial losses, providing a safety net against adverse market movements.
- Enhanced investment flexibility: Hedging enables investors to diversify their portfolios across a wider range of asset classes.
- Time savings: Long-term investors can save time and effort by reducing the need for constant portfolio monitoring and adjustments in response to daily market volatility.
- Flexible pricing strategies: Hedging can facilitate more flexible pricing strategies due to reduced margin requirements.
- Protection from economic factors: Effective hedging provides protection against various economic factors, including commodity price changes, inflation, currency exchange rate fluctuations, and interest rate changes.
- Sophisticated trading techniques: Hedging with options opens doors to more complex trading strategies, allowing traders to optimize their profit potential.
- Increased market liquidity: Hedging contributes to increased liquidity in financial markets by facilitating a wider range of investment activities.
What is hedging against risk?
Hedging is a popular strategy used globally to minimise the risk of investing. Money managers, investors, and fund managers try to hedge a particular investment by buying or trading with another instrument or security that has the potential to move in the opposite direction than their initial investment.
Key takeaways
- Hedging is used as an investment strategy that aims to reduce, offset or limit the risk of an investment.
- One of the most commonly used techniques of hedging is buying derivatives.
- Diversification of a portfolio is also a commonly used hedge, which invests in both a stock that is cyclical and the opposite, which is countercyclical.
Conclusion
Hedging is a vital investment strategy designed to mitigate risk and protect against potential losses. Whether through derivatives, diversification, or specific hedging strategies like spread hedging, investors aim to safeguard their portfolios against unpredictable market movements. By carefully balancing risk and reward, investors can manage uncertainties and stabilise their financial positions.
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