A Beginner’s Guide to Hedging

A Beginner’s Guide to Hedging

Reading time: 6 minutes

For many, investing can be a daunting prospect; many visualise it as a perilous endeavour void of any risk management. Of course, this is untrue. Measures are in place to help navigate market volatility and minimise risk.

Enter hedging.

Hedging in a Nut Shell

Hedging is an approach designed to help lessen risk and is widely employed across the financial markets, such as in the stock market, the foreign exchange market (Forex) and interest rates. At its core, hedging serves as the process of executing an opposite position such that it offsets potential downside in another position or one’s holdings/portfolio.

Understanding Hedging

First and foremost, not all traders employ hedging strategies; some individual traders are comfortable simply employing a protective stop-loss order to control downside risk in unfavourable trades. Nevertheless, many traders and, particularly longer-term investors, will use a number of hedging strategies to ensure risk is minimised as much as possible.

Direct Hedging:

Direct hedging is one of the more straightforward ways to begin using hedging strategies; it involves executing two offsetting positions simultaneously in the same market. An uncomplicated example can be found in the currency market with, say, the EUR/USD currency pair. Should you be long the EUR/USD (a buy position) and believe a correction could be on the horizon (price is at resistance in an uptrend, as an example), rather than liquidating the long (or moving your stop-loss order closer to the price action [which could ultimately take you out of the trade prematurely]), you may decide to simply sell short the EUR/USD to offset any downside in the pair. Importantly, by executing a direct hedge, you would need to consider commissions in your decision. With FP Markets, our commissions are some of the lowest in the industry across major currency pairs, like the EUR/USD.

Derivatives Hedging:

How an investor can employ derivatives as a hedge is best explained through an example. However, bear in mind that there are a multitude of hedging strategies that involve derivatives, ranging from simple to complex.

While hedging can be achieved using futures contracts, swaps, forwards and, of course, CFDs (Contract for Differences), a basic example can be found using options: put options.

As a quick explainer, options are derivatives that provide the holder with the right but not the obligation to buy or sell an underlying asset while the seller (or writer) commits to delivering the underlying asset (yet options are rarely settled physically nowadays; most are cash-settled). A put option gives the holder the right but not the obligation to sell the underlying asset at a specified price (the strike price) on a specific future date (do note that with European options, this expiration date is fixed, unlike American options whereby an option contract can be closed prior to the expiration date).

Let’s say an investor is long the XYZ stock for 200 shares (owns the shares), a protective put option can be employed (in this case, you would need to execute two put options as one put option is equivalent to 100 shares), allowing the holder downside protection below the option’s strike price until its expiration.

Diversification:

Although diversification is sometimes used interchangeably with hedging, they are not the same thing. Hedging refers to mitigating risk, while diversification is the process of maximising gains while also minimising losses.

You may already be more familiar with diversification than you think. Have you ever heard of the phrase: ‘Do not put all your eggs in one basket’? This serves as a good analogy, emphasising the point not to concentrate all your resources in one area or, in the case of the financial markets, not to put all your resources into one asset class.

Diversification works best when assets are uncorrelated or negatively correlated with one another so that as some parts of the portfolio fall, others rise or are unmoved. Diversification essentially means allocating funds among various assets. If one asset takes a loss, the money invested in the others may not be affected.

Final Words

Hedging is a must for many investors to help minimise drawdown, though it is a broad topic and employing hedging strategies can require in-depth knowledge. It is advised to use this article as a stepping stone to furthering your understanding and then begin test-driving different strategies.

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