What is hedging in the stock market?
In the modern world, many economic agents, including market participants, are concerned about fluctuations in prices of various assets. When forming an investment portfolio, the client is always afraid of a decrease in its value due to unfavorable fluctuations in quotations. Hedging strategies can be one of the ways to insure financial risks.
Hedging is used by both private investors and large funds. It’s also used by companies to hedge their specific risks, i.e., airline companies hedge for oil price fluctuations. Even though the hedging premiums are expensive, hedging saves hundreds of millions of dollars in this volatile market in these volatile times. Let’s look at this issue in more detail and learn about the main hedging techniques to invest safely and profitably!
What is hedging in trading?
The first thing that comes to mind when describing hedging in the share market is insurance. By hedging, investors and representatives of the real sector are insured against possible losses, and minimize losses as a result of adverse events.
At the same time, we’re talking about opening corresponding opposite (hedging) positions on similar financial instruments, often with the help of derivatives. You can hedge the risks of changes in the asset price, exchange rate, and interest rates.
How does hedge trade work?
For a more detailed analysis, let’s imagine a simple life situation. There is a farmer who grows wheat. According to forecasts, market prices for grain crops are expected to decrease in the fall. If the forecast turns out to be correct, the farmer will suffer losses. However, they don’t want to take risks and make a deal with the buyer in advance about the future sale of wheat at a fixed price. Thus, the risk of price reduction is minimized.
The basic principle of risk hedge is that an unfavorable change in the price of the hedged asset is compensated by the profit received on another instrument. The classic is the use of derivatives. Among the derivative hedging instruments, the key ones are futures, forwards, options, and swaps.
Types of hedges
The following types of market hedges exist in the market:
- According to the instrument type, hedging is divided into exchange and over-the-counter. Insurance of exchange futures and options contracts is implicit only in exchange trading. The advantages of this risk protection method are the security of such transactions and good market liquidity. In over-the-counter hedging, assets such as forwards and over-the-counter options are protected from risks. The main advantage of this type of insurance is that the investor has maximum freedom to choose the transaction terms. You can independently determine the volumes, prices, and other parameters of the transaction. But such obligations are less liquid, that is, difficulties may arise when closing a transaction.
- According to the type of counterparty, asset insurance is divided into a buyer’s (investor’s) hedge and a seller’s hedge. The need for a transaction of the first type arises in case of insufficient supply volume, or if the terms and delivery dates of the underlying asset are inconvenient for the investor. The seller’s hedge is required in case of insufficient demand.
- According to the size of the insured assets, there’s a distinction between full and partial hedging. In the first case, the volume of the ‘insurance’ transaction is equal to the full volume of the basic transaction. In the second case, only a part of the volume is hedged, which is advisable in case of a low probability of risks.
- According to the terms of the hedging contract, insurance can be divided into unilateral and bilateral. In the case of potential unilateral losses from price, damages are borne by only one transaction participant. And in the second case, the possible losses are divided between the buyer and the seller.
If you’re engaged in investment activity, you can combine different types of such “insurance” and use hedging stocks or bonds. When your investment portfolio consists of 50% of high-risk assets, it becomes mandatory to hedge the market regardless of your personal assessment of the degree of risk. Stocks, for example, are risky securities, so keep both profits and security in mind, and hedge your risks!