You may have heard about hedging before and probably thought it’s something for fund managers and institutional investors, but hedging strategies are meant to help reduce the risk of adverse price movement against open trades. So, hedging is a beneficial practice every investor should know how to use.
In the world of financial trading, hedging — just like the use of stop loss — is one of the risk management strategies enlightened traders use to protect their portfolio. For those who understand the nature of trading, portfolio protection is as important as, or even more important than, making profits because once you are in the market, your capital is exposed to different risks.
The truth is, no one knows when the market will turn against his position or, for stock investors, when the next market crash would come. So, protecting one’s trading capital via hedging strategies may be a very smart approach to trading. But the problem is that most retail investors don’t yet understand the idea of hedging, which is why we created this post to show how investors can take advantage of it.
In this post, you will learn:
- What hedging means
- The reasons for hedging
- The best strategies for hedging
- How traders hedge their positions
- The various ways to hedge your position
- The disadvantage of hedging
Hedging strategies: What does hedging mean?
Hedging, at the most basic level, means opening another trade with the intention of offsetting any losses in the first trade with the gains from the second one. So, it helps to keep losses at a manageable level or even secure some profit where possible.
Think of it as a form of insurance. When you buy a car or house insurance, you are hedging against the impact of unforeseen events, such as fires, damages, and others, on your finances. It is almost the same with hedging in the financial markets, where you make use of certain strategies to protect your position from negative events in the market.
However, hedging in financial trading is not as simple as paying a premium each year to cover your positions against all negative events; it is more complicated than that. Firstly, hedging in financial trading does not totally protect your position from all negative events, but if you do it properly, it can reduce the size of your potential losses in the case of a negative price movement. Secondly, financial market hedging requires special strategies.
A hedging strategy is a set of techniques used to reduce the risk of losses in event of an adverse price movement against your trading positions. It usually involves taking the opposite trade to the one you
want to hedge. This can be in the same security or in a related security — one of the commonest methods of hedging in forex trading.
Hedging also involves placing offsetting trades in securities with negative correlations. For instance, investors do buy U.S. government bonds to hedge their positions in the stock market.
However, there are other ways to hedge, which involve the use of complex derivatives, such as forward, futures, and options contracts, as well as swap deals. One can even say that those derivatives were created for managing risk in the underlying assets. For instance, investors often prefer to pay a premium to buy put options on the stocks they are invested in or on the S&P 500 Index when they think that the stock market is in danger of a selloff.
Some investors also use futures or forward contracts to hedge their positions. With these derivatives, people exchange an asset at a predetermined price at a specified time in the future. These sorts of contracts are common with the stock and commodity markets. At the time of fulfilling the contracts, the price of the asset may have gone up or down, so either the buyer or the seller would have lost out on the opportunity to make more profit while the other would have prevented an occasion of a loss.
So, whether it is with options or futures/forward contracts, hedging comes at a cost — the premium you pay for options or missing an opportunity to make more profit in the case of a forward or futures contract. Hence, while hedging can help you to reduce risk, it also reduces your potential profit.
Even when using portfolio diversification as a way to hedge risk, there is still the possibility of reduced profit potentials because when some securities are making profits, others are losing.
In essence, hedging is a strategy to reduce risk and never a way to make more money. When your position is making money, your profit potential reduces because of the cost of hedging, but if you are in a losing position, your potential losses would be minimized if the position was properly hedged.
Hedging strategies: the reasons for hedging
Hedging strategies are normally used to protect against adverse price movements over the short term or medium term, so most long-term investors don’t bother about hedging because they don’t feel threatened by short-term adverse price movements. However, hedging is very important to short-term and mid-term traders. For this group of traders, hedging is not meant to generate profit but to reduce their potential losses when the market moves against their positions.
Hedging is very common in the currency market because both forex traders and corporations operating internationally who are exposed to foreign exchange risk make use of it in protecting against exchange risks. Aside from the currency markets, active players in the stock, commodity, and cryptocurrency markets also make use of hedging strategies.
So, different market players have different reasons to make use of hedging — it could be to protect their trade from price volatility, to avoid liquidating their stock portfolio or protect their profits, to combat foreign exchange risk, to prevent commodity risk, to reduce interest rate risk, to reduce cryptocurrency risk, or to avoid credit risk.
Reducing volatility risk in forex trading: The forex market is very volatile, so forex traders always try to find a way to reduce their risk exposure. Many do that by putting a stop loss order
- whenever they are in a trade, but some, especially the professional traders, make use of forex hedging strategies, which could be as simple as placing two opposing orders in the same currency pair, using multiple currency hedging by taking similar trades in two negatively correlated currency pair or opposite trades in two positively correlated pairs or making use of forex options where the buyer has the right to exchange a currency pair at a set strike price on a specified future date.
- Minimizing equity risk: This is the risk that your stock portfolio will depreciate as a result of stock market dynamics. Most investors try to protect against this by diversifying their portfolio into those assets that negatively correlate with the stock market, such as government and A-rated corporate bonds and safe-haven commodities like gold. Others may buy protective put options or sell call options.
- Reducing foreign exchange risk: This sort of risk is experienced by financial investors when investing in a foreign market, corporations that have international operations, or any person who has a need to use foreign currency. People in this situation can make use of options, futures, or forward contracts, as well as specialized exchange-traded funds (ETFs).
- Preventing commodity risk: Here, the risk arises from fluctuations in the prices of the commodities in question, which can be metals, energies, or agricultural products. Producers of these commodities and the companies that depend on them often use futures contracts to hedge against price fluctuations.
- Reducing cryptocurrency risk: Bitcoin and other cryptocurrencies are notoriously very volatile, and since they are not regulated, they are considered very risky investments. So, some cryptocurrency traders see the need to hedge their investment using derivative contracts, such as options and futures, as well as short selling.
- Reducing interest rate risk: This risk arises from the fact that the relative value of an interest-bearing liability, such as a loan, Treasury bills, notes, or bonds, may worsen due to a change in interest rate. Investors hedge interest rate risks using fixed-income instruments or interest rate swaps
- Avoiding credit risk: This is the risk that money you are being owed may not be paid by the debtor. Naturally, banks are in better positions to manage credit risks than commercial businesses, as banks have better resources to collect the debts. So, it is better for businesses to sell their credit obligations to banks at discounted rates.
Hedging strategies: the best strategies for hedging
From our discussions so far, you could see that there are many strategies for hedging, and some are better suited for certain categories of risks than the others. Here, we will discuss a few of the most commonly used hedging strategies, irrespective of the markets where they are used. The ones we will discuss include:
- Hedging with the same instrument
- Pair trading
- Hedging with options
- Hedging with futures/forward contracts
- Hedging with other assets
Hedging with the same instrument
This is also known as direct hedging. It is a strategy where a trader, who already has a position in an instrument, temporarily opens an opposing position in the same instrument when the price is moving against his initial position so as to offset the losses until the market turns back in the direction of the initial position. This strategy is commonly used by those who trade currency pairs and CFDs on indices.
For instance, say you have a long position in the EUR/USD, and then, there is a dovish report from the European Central Bank; you may temporarily open a short position to manage the expected adverse price movement that would follow the report. You may hold the short position until the price starts advancing again.
While it may be difficult to get the timing of the hedging trade right, this type of hedging offers the benefit of being very easy to implement, and it allows you to keep your initial trade during the period of adverse price movements, while you can remove the opposing trade when the price starts moving in the expected direction.
With this hedging strategy, the trader simultaneously opens a long position in one instrument and a short position in another instrument that is related to the first one but currently trading differently. For instance, the first instrument is undervalued and has the potential to climb, while the second one is overvalued and starting to decline. The pair automatically creates a hedge because each trade reduces the risk in the other.
Pair trading can be used in currency, indices, and commodity trading if the two instruments are correlated with one undervalued and the other overvalued, but it is mostly used in trading stocks. Here, you choose stocks in the same industry, but one must be in a stronger position and the other, in a weaker position.
If the industry is in a bullish phase, the stronger stock, in which you have a long position, would advance more than the weaker stock where you have a short position, so you are still in profit. On the other hand, if there is bad news that affects the industry, the weaker stock where you have a short position would decline faster than the stronger stock where you have a long position. At the end of the day, you’re still making profit, which is why pair trading is considered a market-neutral strategy.
Hedging with options
Options are derivative contracts that give the buyer the right, but not an obligation, to buy or sell an underlying asset at a specified strike price before or on the specified expiration date of the contract. There are two main types: put options, which gives the buyer the right to sell the underlying asset and call options, which gives the buyer the right to buy the underlying asset.
Many professional investors make use of the options market when trying to hedge their positions in the stock, forex, or commodity market. For the most part, they buy protective put options when they think that the market is about to tank, but some may also sell call options if they suspect a choppy market.
There are options contracts for the popular stocks like Amazon, Microsoft, Facebook, and a few others, so traders with positions in those stocks can buy the relevant put options at a strike price that not only protects their capital but also offers them some profits, depending on the prices they bought the asset initially. For stocks that do not have single stock options, investors tend to buy the S&P 500 Index put options when there is a stock market turbulence.
The buzz in the options market, especially the S&P 500 options, during periods of market downturns is the reason the Chicago Board Options Exchange (CBOE) developed the Volatility Index (VIX), which is based on put and call options of the S&P 500, to track the emergence of bear markets by tracking the activities of professional investors in the options markets as they try to hedge their positions in the stock market.
Hedging with futures/forward contracts
Futures are standardized contracts that trade on an exchange, which obligates the parties to transact the underlying asset at a predetermined price on a specified future date. Forward contracts are similar to futures, but they trade over the counter and are not standardized.
Many professional speculative traders in the commodity markets, as well as corporations that are exposed to currency risks, make use of the futures and forward contracts in hedging their positions. Originally, the futures market was made for farmers, producers, and major consumers of real commodities to protect themselves against price fluctuations before speculators flooded the market.
For instance, say Company A manufactures coffee drinks and Company B is a major coffee farmer. If Company A thinks that the price of coffee will rise in the next 6 months, it may buy a futures contract for the delivery of coffee in 6 months’ time. Similarly, if Company B thinks that the price of coffee will fall in the future, it may sell coffee futures contracts and lock in profit at the present price.
Hedging with other assets
Some stock traders and investors tend to hedge their position in the stock market by buying assets that increase in value when there is a stock market turbulence. Two common assets they buy are bonds and gold.
When there is a sign of a downturn in the stock market, investors tend to buy more bonds and other fixed-income securities. As investors rush to the bond market, the yield falls, but that does not deter them as they seek the protection offered by these assets, especially the U.S. government bonds. See the chart below showing the relationship between the S&P 500 Index and the 10-year Treasury Note.
Gold is considered a safe-haven asset because it tends to increase in value during periods of inflation and economic crisis. It is also inversely correlated with the USD, hence, when USD is declining, gold prices go up.
Investors often buy gold to protect their stock portfolio during periods of economic crisis and may also use it to hedge against a drop in the USD. Research showed that gold is the best hedge against stock market turbulence as the price tends to increase dramatically during the 15 days following a stock market crash. See the chart below comparing the US Dollar Index with Gold.
Diversification is the process of allocating your investment capital to different securities with a view to reducing your exposure to one particular asset or industry. While many do not consider it a hedging strategy, diversification helps to protect your portfolio from market volatility. Naturally, the purpose of diversification is to reduce non-systematic risks, so it’s a hedging strategy by nature.
With portfolio diversification, you build your investment portfolio across several asset classes and different markets, including stocks, real estate, commodities, currencies, precious metals, bonds, arts, and others, at the very beginning.
Hedging strategies: what traders consider before hedging their positions
Like we said before, hedging costs money, and the primary purpose is not to make more money but to reduce potential risks. So, experienced traders ensure that a hedging position is worth the cost before putting it on.
Another thing they consider when they think that hedging is necessary to protect their positions is how much they have for hedging and if they want to completely or partially hedge their position. To achieve neutral exposure, traders place equal long and short positions in two or more markets at the same time. The key is trading related markets that move differently, so they have to sure that the instruments meet the criteria.
Hedging strategies: ways to hedge your position
There are many financial instruments you can use to hedge your position, depending on the market you are trading. Most times, it is easy to hedge with the instrument you are trading or another one with similarities to your primary instrument. What matters is understanding the nature of the price movements and ensuring that the positions you enter can offer you the level of hedging you desire.
You may also use derivative products, such as options, futures, and CFDs, especially if you are trading stocks or commodities. Buying put options helps you to secure your profits against violent price downturns. Futures are very useful for commodity trading if you want to take delivery of the asset, while CFDs offer the benefits of trading purely price difference without worrying about the underlying asset.
Hedging strategies: Disadvantages
No matter how you look at it, hedging has a cost, and it comes in different ways. It could be the cost of opening a new position in the same or another instrument, the premium you pay for a put option contract, or missing an opportunity to make more profit by being on the wrong side of a futures contract.
There is no way to avoid the cost, so it’s necessary to determine whether the benefits justify the cost before trying to hedge your position.
There are numerous hedging strategies available to traders and investors. Some of them are more suitable for certain markets. Consider the market you are trading before choosing the best strategy for your position. Whatever you choose, know that hedging only helps to reduce losses and it comes at a cost.