Hedging is an investment strategy aimed to managing the overall risk caused by adverse price movements. It is simply a tool which enables investors in protecting their finances from being exposed to risky situation and eventually leading to heavy losses. Hedging can also be called insurance of investment world that protect and reduce ill-effects of negative events on individual’s finances. This strategy of risk management offset the overall losses associated with investment activities by holding opposite position in related asset. However, reduction in risk by utilizing hedging also leads to reduction in potential profits.
Hedging recognizes all sort of danger that may come with each investment and acts like a shield towards them. It technically prevents risk by holding investment in two types of instruments having adverse correlation. Hedging do not entirely safeguard the investment avenues from facing losses but only bring down the extent of negative impact arising out of unforeseen situations. More commonly, derivatives are used for doing hedging in world of investment that are securities moving in correspondence to one or more underlying assets. These securities include future contract, forward contract, swap and options. Underlying assets may be currencies, bonds, stock, commodities, interest rate or indices. A trading strategy can be easily set up by using derivatives where loss arising out of one investment is offset by gain in comparable derivative.
Strategies of Hedging
Hedging strategies are of multiple types and each one of them have some uniqueness. Using these strategies as per the type of investment can good results. Some of the common hedging strategies are discussed in points given below: –
- Diversification: Diversification strategy says never to hold investment in only one type of security but go for variety of assets that are unrelated to one another. Putting funds across multiple range of assets helps investor in reducing losses as loss incurred in one asset can be easily offset from other assets earning. The strategy is based on famous quotation “not to put all your eggs in same basket’’, and this is actually valid in field of finance. For instance, an investor purchase securities of automobile industry, hotels, shopping malls and private hospital. Now suppose, if due to some negative event, the tourism industry where hotel operates get fail in their operations and suffer losses then overall investment will not be affected as they all are not related with each other.
- Arbitrage: Arbitrage strategy of hedging is simply a clever strategy where product is purchased and sold immediately for making profits. It involves buying product from one market at lower price and selling it at higher price in another market in short period of time, thereby making small but steady profits. Arbitrage strategy is more commonly used in field of stock market. A very simple example of this strategy can be a person buying watch for $55 from local store nearby his locality and then sell it for $80 to his friend. The person’s friend is quite happy to get same product at $80 which is cheaper in comparison to departmental store that is charging $100 for same product.
- Average Down: Average down strategy involves purchasing additional units of product when its cost or selling price get declined. It is more used by stock investors for hedging of their investment held. When the price of stock purchased by them falls down, they buy more units of share at lower price to take advantage of future price rise. The loss arising out of initially purchased stock gets offset from the profit resulting from secondly purchased stock due to rise in their prices.
- Staying in Cash: The staying in cash strategy of hedging is called “No Investment’’ strategy. It is as simple as it sounds where no investment is made by investor in any asset. The investor holds all of his money in cash, hedging it against any potential losses that may arise in his investments.
Ways of doing hedging by investors
The investors/AMC hedge their investment for mitigating losses employing following strategies: –
- Asset Allocations: Asset allocation is one where there is a diversification of investor portfolio by taking assets from distinct classes. Balance of investment is made via allocation of funds into varied class of assets thereby reducing ill effects of potential losses. For example, a person investing 40% of his funds in equity market and rest in assets having stable returns. Here, overall impact of losses will be minimized as if there are losses in equity assets then it can be offset by income from stable assets.
- Structure: Structure strategy means using derivatives and debt instruments by investor for hedging of his investment. Under this, a certain part of portfolio is invested in debt instruments and remaining in derivatives. A portfolio gets stability by doing investment in debt while investment in derivatives give protection from multiple risks.
- Through Options: This involve securing the portfolio directly by including options of calls and puts of assets. Options are contract through which buyer get rights but is not under any obligation to buy or sell the underlying asset once its price reaches a certain level -at or before the expiry date. There are two types of options which are: – Call options and put options. Call option provide right to holder but not obligation to buy asset. On the other hand, put option gives right to holder but not an obligation to sell an asset.
Advantages of Hedging
The advantages of hedging can be well-understood from points given below: –
- Limits the loss for individual: First and foremost, advantage provided by hedging technique is that it limits the loss for investor. It limits losses for individual in the scenario of black swan event. The black swan event are unforeseen events which takes place rarely and has great potential in bringing massive destruction to wealth in financial markets. When a person hedges his funds then he is simply getting protection against distinct types of risk. For instance, person buying insurance policy for protection of his car from accidental or fire damage is simply hedging. Now if car gets damage worth $2500 due to road accident and insurance company bears the loss of $1800 then individual loss for person is of $700 which is because of hedging.
- Increase liquidity of investors: Hedging provides a useful benefit of enhancing liquidity in financial markets such as stock market, derivative market and commodity market. People when hedging their funds allocate them in distinct markets that bring down the overall loss leading to ample liquidity across different markets. In presence of adequate liquidity in market, better price discovery for asset under consideration is achieved.
- Preserve capital of investors with low risk tolerance: The technique of hedging enables trader and investors in preserving their capital and achieving peace of mind. Hedging is very useful for peoples having lower tolerance for risk as it works toward securing their investment against market risk. Both investors and trader are able to make consistent gains along with peace of mind as they are taking much risk.
- Saves time: Hedging strategy of investing saves time as there is no need to adjust the portfolio with daily market volatility by long-term traders. It helps trader in surviving hard market periods by providing shield against high and irregular market fluctuations. Also, traders by utilizing options get an opportunity to maximize their returns via practicing the typical option trading strategies.
Disadvantages of Hedging
Various disadvantages of hedging are as follow: –
- Costly: Hedging is not done for free and there are distinct costs associates with this investment strategy. There are charges in the form of brokerage and premium in case of derivatives, and in case of insurance, the insurance premium is paid by person on fixed period basis. Therefore, many people do not consider hedging while taking investment decisions because of its associated costs that they consider unnecessary.
- Limits the profit: This is another major limitation of hedging technique which reduces the return earning potential of investors. Hedging offers muted returns as it eats away from investor return stream. The investors can gain using hedging only when sudden rise is expected by them in market volatility. However, if market is performing good and returns are expected to go up then hedging will drag down the portfolio performance.
- Do not protect from all risk: Hedging does not provide protection from all type of risk but only reduces negative impact of unfavorable market events. Not all risks can be fully hedged or covered under it, like in case of insurance also some loss is borne by insured himself. Also, every asset class do not have the corresponding hedge in case of financial markets.
- Require high skills and experience: This strategy of investment requires higher skill set and experience for practicing in trading activities. It is a precise strategy of trading which is successful in protecting against market risk only when applied successfully after through analysis of available investment avenues.