Hedging 101

Overview
Naturally, investors are keen on protecting their finances from incurring massive losses by crafting robust trading strategies and risk management tools. In this article, we will highlight one of the most widely used risk management techniques, hedging.
outcome

What is hedging? How does it work? And what are its strategies?

Reading time
10 minutes
Experience Level
  • beginner Beginner

What is hedging?


Hedging is a risk management method that investors in financial markets adopt to protect their trades from possible inflation risks. This can be done by buying shares or other assets that are likely to go up during a general rise in price levels. Hedging is also a must-know for all investors who plan on protecting their portfolios. 


Although many investing strategies have been developed decades earlier, hedging was first introduced in 1949 as part of an article written by the American-Australian journalist Alfred Jones. The paper examined strategies investors can use to gain higher returns and proposed the concept of hedging as an answer.



How does hedging work?


Hedging is similar to having insurance on your assets protecting them from potential risks. Since an investor cannot escape market risks, they ought to prepare their portfolio for the inevitable unexpected dangers. But how can hedging do that?

Let us imagine the following scenario to understand how hedging works:

Investor (A) owns shares in a company with great potential, but the fear of unforeseen market risks – that could cause short-term losses – keeps them awake at night. After a long search, the investor discovered hedging, which is taking the opposite position of an asset they own so when the original investment goes under, the value of the second one goes up. Therefore, Investor (A) will save their portfolio from a massive hit since the gains of the second asset will cover the losses of the first.


Types of hedging strategies


Hedging strategies take many forms, depending on the financial market and instruments the investor is interested in. Here are some of the most common ones:

  • Use of derivatives such as forward contracts, futures contracts, and options contracts.
  • Pairs trading. You may have heard of the saying "don't put all your eggs in one basket" ever since you started trading. Pairs trading manifests the famous advice since it allows you to trade on two different assets with opposing values, and in case one faces a loss, the other one will compensate for it.
  • Trading safe-haven assets such as gold, government bonds, and currencies like the USD and CHF.

There are many practical hedging strategies with no particular one that suits them all. Each trader has different objectives with varying resources. For that reason, we advise you to choose the hedging strategy that best suits your assets and trades.

Advantages of hedging


There are many benefits to taking up a hedging strategy, including:

  • Minimizing losses.
  • Increasing liquidity.
  • Offering flexible price mechanisms.

As we all know, there are no guarantees in the world of trading with the never-ending financial market turnarounds. Adopting a hedging strategy can help protect your investment portfolio as much as possible.


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