Hedge refers to an investment strategy that protects traders against potential losses due to unforeseen price fluctuations in an asset. It primarily requires investors to holding in one financial market and then taking a position in a different market to offset the loss.
A hedge mitigates the risk of dramatic price swings in financial assets through alternative investmentsAlternative InvestmentsAlternative investments refer to investments made in assets classified as non-traditional investment vehicles.. Traders can invest in stocks, derivativesDerivativesDerivatives in finance are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be bonds, stocks, currency, commodities, etc. The four types of derivatives are - Option contracts, Future derivatives contracts, Swaps, Forward derivative contracts. , swapsSwapsSwaps in finance involve a contract between two or more parties that involves exchanging cash flows based on a predetermined notional principal amount, including interest rate swaps, the exchange of floating rate interest with a fixed rate of interest., optionsOptionsOptions are financial contracts which allow the buyer a right, but not an obligation to execute the contract. The right is to buy or sell an asset on a specific date at a specific price which is predetermined at the contract date. and futures contracts, ETFsETFsAn exchange-traded fund (ETF) is a security that contains many types of securities such as bonds, stocks, commodities, and so on, and that trades on the exchange like a stock, with the price fluctuating many times throughout the day when the exchange-traded fund is bought and sold on the exchange., etc., designed to balance against the risk of sudden price changes. Although hedging minimizes losses with gains from another investment, it does not guarantee that assets will not lose value.
Table of contents
- Hedge definition describes an investment strategy used by traders to protect their investments from risks of heavy price fluctuations in an asset. Alternative investments like stocks, derivatives, swaps, options and futures contracts, and ETFs can help offset losses caused by abrupt price changes.
- It works similar to insurance, which protects a person’s assets, such as their home or car, against damage caused by fire or accident.
- Common hedging tactics used by traders include derivatives, diversification, spread, and arbitrage.
- There is no such thing as a perfect hedge, and even if there were, it would not be a fool-proof approach because no loss can be averted ever.
How Does Hedge In Finance Work?
A hedge is a risk management practice adopted by investors and traders to ensure that price fluctuations do not negatively impact their financial position in the market. This investment approach ensures that if one’s holdings lose value, investing in another asset can make up for that. Technically, hedge lessens the impact of possible loss, no matter how big it is, rather than eliminating the risk.
It is comparable to insurance, which covers a person’s properties, such as a house or automobile, against fire or accidental damage. In a nutshell, hedging is a form of investment insurance.
Investors can protect the share of profits through hedging. Adding a hedge to a position minimizes the risk or reverses the effect in the event of a loss. Similarly, a beta hedge can save a financial portfolio from any adverse market scenario.
Beta hedging signifies investing for a position to avoid unsystematic risksUnsystematic RisksUnsystematic risk refers to risk that is generated in a specific company or industry and may not be applicable to other industries or the economy as a whole. There are two types of unsystematic risk: business risk and financial risk.. Investors use this strategy to protect their portfolios by purchasing stocks for beta holdings. Furthermore, there are two ways of hedging a position – single position and group position hedging. Hedging through derivatives and portfolio diversificationPortfolio DiversificationPortfolio diversification refers to the practice of investing in a different assets in order to maximize returns while minimizing risk. This way, the risk is kept to a minimal while the investor accumulates many assets. Investment diversification leads to a healthy portfolio. are two typical methods for taking offsetting positions to a current holding.
Investors suffer no losses when hedging is perfect, i.e., eliminates potential risks in holding a portfolio or financial position. It, thus, provides complete protection against price swings in the most sensitive assets. A perfect hedge, however, cannot be a fool-proof strategy as no loss can be averted. Even the so-called perfect hedging is not fully insured.
Investing strategically in multiple financial assetsFinancial AssetsFinancial assets are investment assets whose value derives from a contractual claim on what they represent. These are liquid assets because the economic resources or ownership can be converted into a valuable asset such as cash. is considered the best way to reduce exposure to sudden changes in prices. For example, investors or money managers purchase stocks, expecting the price to rise in the coming days. Then, they plan on selling those stocks when the price goes up. However, if the price drops adversely, they will end up losing. In such a scenario, options tradingOptions TradingOptions trading refers to a contract between the buyer and the seller, where the option holder bets on the future price of an underlying security or index. can help them add a hedge to a position to negate or reduce the effect, thus balancing the loss. However, it limits possible gains owing to risk mitigation.
This concept is not as simple as insurance, where investors pay a premium every month to safeguard their assets. Instead, it is all about investing smartly to offset its side effects. In short, investors, portfolio managersPortfolio ManagersA portfolio manager is a financial market expert who strategically designs investment portfolios., and traders can protect one investment by investing in other stocks simultaneously. Thus, it might act as a backup plan for traders so that unexpected fluctuations in stock prices do not affect them.
Investors adopt multiple hedging strategies to protect their investments from potential losses. However, these strategies and pricing of respective assets are contingent on the sort of underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates. and its downside riskDownside RiskDownside Risk is a statistical measure to calculate the loss in a security’s value due to variations in the market conditions. Also, it refers to the uncertainty level of realized returns being much lesser than the anticipated ones. . The cost increases as the downside risk grows due to volatility. Some of the common strategies they use are:
#1 – Diversification
Money managers should avoid investing in a single financial instrument or asset. Instead, they should diversify their portfolio by investing in a variety of non-related assets. Doing so would protect them with profits from hedging investments even if they incur huge losses from other trades. Also, no two assets rise and fall at the same time, and hence minimizing the loss. Thus, diversified hedging is one of the best and most recommended ways of ensuring portfolio protection.
#2 – Derivatives
Derivatives are financial contracts that derive their value from an underlying security, making it one of the ideal hedging strategies. Investors can choose to invest in stocks, options and futures contracts, bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period., indices, swaps, and commodities. In this strategy, any gain in the derivative security offsets any loss on a single investment.
For example, gold is a hedge because of its price stability against inflation. Similarly, trading options enables traders to buy or sell equities at a predetermined price within a specified time frame.
#3 – Spread Hedging
It works like this that the investor purchases a put for an index at a higher strike price and then sells it at a lower strike price at the same expiry date. The difference in strike pricesStrike PricesExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market. acts as a hedge against potential loss due to changes in the index price.
#4 – Arbitrage
A trader uses this arbitrageArbitrageArbitrage in finance means simultaneous purchasing and selling a security in different markets or other exchanges to generate risk-free profit from the security's price difference. It involves exploiting market inefficiency to generate profits resulting in different prices to the point where no arbitrage opportunities are left. strategy to buy a financial instrumentFinancial InstrumentFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes. at a low price and then sell it immediately at a higher price in a different market. It may not yield high returns, but it does provide traders with consistent profits.
Let us look at the following examples of Hedge to understand the concept even better:
Mary invested in stocks of an automobile company, expecting the price to rise in the future. However, as an experienced trader, she was well aware of the stock market’s risks. As a result, she decided to have a backup plan in case of a price fall.
She decided to invest in gold to be safe. The best way to protect against currency depreciationCurrency DepreciationCurrency depreciation is the fall in a country’s currency exchange value compared to other currencies in a floating rate system based on trade imports and exports. For example, an increase in demand for foreign products results in more imports, resulting in foreign currency investing, resulting in domestic currency depreciation. is to invest in precious metals. Furthermore, gold preserves its value regardless of the value of the currency.
A study from the American investment advisor Vanguard revealed that commodities are the most effective investment instruments to hedge against sudden inflation. It observed that for every 1 percent of inflation beta in the U.S., the commodity marketCommodity MarketThe commodity market is a place where people buy and sell positions in commodities such as oil, gold, copper, silver, barley, wheat, and so on. Started with agricultural commodities, there are now fifty main commodity markets throughout the world, dealing with over a hundred commodities. grew by 7-9 percent during the last decade. Since raw materials and agricultural products tend to rise in prices during hyperinflationHyperinflationHyperinflation is merely an accelerated level of inflation that tends to quickly destroy the actual value of the local currency since there is a rise in the cost of all products and services, and it causes people to lower their holdings in that particular currency as they opt to participate in foreign currencies that are relatively more stable., commodity investment is a more effective hedge against inflation than equitiesEquitiesEquity refers to investor’s ownership of a company representing the amount they would receive after liquidating assets and paying off the liabilities and debts. It is the difference between the assets and liabilities shown on a company's balance sheet..
Risks In Hedge
Hedging a position can protect an investment against price swings, but traders should be aware of the following hedge risks:
- Hedging against unfavorable price fluctuations requires investment with previously earned profits.
- It does not guarantee complete protection, and the safety against potential loss could be minimal too.
- It will rarely result in a money-making opportunity.
- It is not a viable strategy for traders who trade on a buy-and-hold principle.
Frequently Asked Questions (FAQs)
Hedge refers to an investment strategy that protects traders against the dangers of volatile asset prices. It entails investors holding a stake in one financial market and then acquiring a position in another marketplace to compensate for the loss. It limits the amount of money lost in addition to minimizing or offsetting the potential risk.
The most common hedging strategies include:
• Diversification (making diverse investments)
• Derivatives (investing in stocks, options and futures contracts, bonds, indices, swaps, and commodities)
• Spread hedging (buying a put on an index at a higher strike price and selling it at a lower strike price at the same expiration date)
• Arbitrage (buying an asset and selling it immediately in a different market when the price increases)
Not all types of hedging are illegal. However, hedging against Forex trading is considered illegal in the United States. It is because it involves buying and selling currency pairs at the same or different strike prices.