A Brief Explanation of Hedging!

By Vishweshwar HS,     www.showmytrade.com

Almost everyone will have a big dream of earning an infinite amount of money! The stock market is one of the best options to do so. In stock market parlance, it is vital to note how much you desire to earn for what risk? Without a proper risk assessment and risk mitigation plan, it is possible to lose to substantial or all investment. Hedging is a critical tool in the hands of a disciplined investor/trader. The stock market beginners need to learn what hedging is, how it works, and what hedging techniques to used for surviving and earning money from the stock market. 

What is Hedging?

The simple way to understand hedging is to think about insurance. People take life insurance, medical insurance, motor insurance, and property insurance to indemnify (set-off the loss) against any adverse events. This insurance doesn’t prevent adverse events from happening, but it happens we can have compensation for such events.

Strategically using the financial instrument or market strategies to offset the risk of any adverse price movements is called Hedging in investment or trading activity. In simple terms, investors/traders hedge one investment by taking the opposite position in another asset class.

Risk is part and parcel of investing/trading activity. One needs to have a basic working knowledge of hedging will lead to better and controlled investment and trading activity. The stock market is volatile. Hedging ensures risk management.

In the financial market, portfolio managers, institutional investors, funds will use hedging to reduce various risk exposure to their investment. However, hedging is not as simple as getting insurance—however, many instruments, tools, and strategies are involved to hedge the portfolio investment.

Technically, to hedge: 

(1) one should make offsetting trades in securities with negative correlations.

(2) Extra money (premium, margin money, etc.) needs to invest in taking offsetting trades.

Some of the Hedging Examples

1. Equity shares & futures contract

For example, if you bought 600 shares of a company at Rs 500/each for three years horizon. If the share price starts to decline, you can short (sell) in the future contract of the same stock and makeup whatever loss if the price declines in that stock. Thus fund manager keeps the equal value though the price of that stock goes down.

2. Calendar spread near month future and next month future contract

For example, if you take a long position in a futures contract, if the price is going down, you can take next month's short position of the same stock. Thus you can hedge your position. You exit your position at an appropriate price.

3. Portfolio of stocks & Index/sub-index

For example, let’s say you have a portfolio of stocks; if the stock market is going down, you can sell an equal amount of Nifty 50 or Bank Nifty futures. Thus, one can cover your notional loss by hedging with an Index or sub-index.

4. Physical Agri commodity, Currency, Crude, Gold, etc. & Futures contact

Hedging in done most of the commodity, currency, crude, gold, etc. where you can lock the price, quantity at now. When products/ goods come to the market, if the price is higher than the previously agreed price, one can make a profit by selling the futures contract. If the price is lower than the previously agreed price, one can take delivery of the product. Thus, hedging effectively locks in the price. 

Hedging is to reduce the risk. But it also reduces the potential profits as involves cost. It is imperative to note that hedging is a technique to reduce possibly uncontrollable loss; it is not any profit-making technique. 

Hedging is not the same as speculating (taking the directional call to make a profit and accepting the risk if moves opposite side) or arbitration (buying at a lower price in one market and selling in the other market for a higher price for a small profit).

Disadvantages of Hedging

Hedging needs extra money in the form of premium, margin money, etc. Before hedging, one must also ensure that hedging is more beneficial as they have a cost element to it. This additional price you pay to avoid uncertainty.

In a volatile market, it is not possible to perfect hedge the portfolio. Although traders are always aiming for the perfect hedge, it is difficult to achieve in practice.

Bottom Line

In the financial market, risk is an essential element of investing. Hedging is a risk management strategy employed to offset losses in investments. The reduction in risk typically results in a decrease in potential profits. Hedging strategies usually involve derivatives, such as options and futures. Learning and deploying the derivatives (Index & stock futures and options) will help to manage risk. Remember, handling the risk is a critical component in the stock market; if not, one loses substantial or all the money!

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Thanks for reading.

Good Earning!

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