What is Hedging in Trading? STATES that ‘Hedging‘ is a Risk Management Technique that aims to PROTECT Investments against adverse price Movements. It INVOLVES a trade that acts as Insurance against potential losses in an existing position, thereby traders aim to limit their exposure to risk, stabilize their portfolios.
What is Hedging in Trading? – Types
| Futures |
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| A Futures Contract is an ‘Agreement to buy or sell an asset at a predetermined price on a SPECIFIED future date’. By entering into a futures contract, traders can protect themselves from potential price fluctuations. For instance, if a trader holds a portfolio of stocks, they can hedge their position by selling stock index futures. |
| Options |
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| Options ‘Provide the right, but not the obligation, to buy or sell an asset at a predetermined price within a SPECIFIC time-frame’. Traders can use call options to hedge against potential price increases or put options to hedge against price declines. Options offer flexibility and allow traders to limit potential losses while still benefiting from favorable price movements. |
| Derivatives |
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| Derivatives are ‘Financial Contracts whose value derives from an underlying asset‘. Hedging can also be achieved through various Derivative Instruments, such as Swaps, Forwards, and Exchange-Traded Funds (ETFs). For Example, ‘Currency Swaps’ can help PROTECT against foreign exchange rate fluctuations, and ‘Commodity Futures’ can hedge against price volatility in Raw-Materials. |
Hedging Strategies – How to Use?
Hedging Strategies can VARY depending on trader’s objectives, risk tolerance, and Market conditions.
- Long and Short Positions: By taking simultaneous long and short positions in related assets, traders can OFFSET potential losses. For example, if a trader holds a long position in a specific stock, they can take a short position in another stock from the same industry, thus reducing the industry-specific risk.
- Pair Trading: Pair trading involves simultaneously buying one asset while short-selling another asset that has a historical correlation. By anticipating the convergence of the prices of these two assets, traders can PROFIT from the price difference between them, irrespective of the Market’s overall direction.
- Stop Loss Orders: Stop loss orders are instructions given to brokers to automatically SELL a security if its price falls below a specified level. Stop loss orders act as a form of hedging by limiting potential losses in case of adverse price Movements.
- Hedging with Options: Options provide traders with the FLEXIBILITY to hedge specific risks. Traders can buy Put options to protect against price declines or use Call options to hedge against potential losses in short positions.
The Bottom Line
What is Hedging in Trading? a Concept which is a CRUCIAL Risk Management Tool in trading that helps protect investments from potential losses caused by adverse price Movements. Traders Employ various ‘Hedging Strategies’, INCLUDING Futures Contracts, Options, Derivatives, and Diversification to Minimize their exposure to risk.
Implementing these ‘Strategies’ REQUIRES a deep understanding of the Market, Risk Appetite, and the SPECIFIC goals of individual traders. While hedging cannot eliminate all risks, it can provide a level of stability and protection allowing traders to navigate uncertain Market conditions with greater confidence.
Chartered Accountant – ICAP
Bachelor of Accounting (Honours) – AeU, Malaysia