Risk is an essential element for any type of investing. The risk in the financial market may or may not be the same as the common assumption of making a loss. Hedging an investment in common terms means protecting your investments and finances from a turbulent or risky situation.
Now how do you manage your risks?
Since risk is almost unavoidable the only option left with us is to mitigate risks or to hedge them.
Hedging Meaning with Example
Hedging is similar to insurance. It limits your loss to a certain known amount. Just like home insurance, you pay a certain fixed amount each month or each quarter. If one night, your house suffers from a fire, the insurance coverage will take care of the damages to the property. Hedging generally involves the application of derivatives, such as options and futures contracts to create positions that would offset those losses.
For instance, you own shares of Tata Motors. You strongly believe in the company for the long run, however, you are worried about the short-term losses in the automobile industry. To protect yourself from the fall in Tata Motors, you can buy a put option on the company that gives you the right to sell Tata Motors at a specific price. If the stock price plummets below the specific price, these losses will be offset by the gains in the put option.
We have various strategies to hedge our investment portfolios. Broadly these strategies can be classified into the following:
- Stock Hedging
- Futures Hedging
- Options Hedging
Types of Hedging Strategies with Example
The simplest way to hedge is using stocks themselves. A few of the strategies within this category could be:
- Short selling or long-short strategies
To mitigate the risks on an existing long position, we can take an offsetting short position. For instance, if we have a long position on a stock and we believe that some correction is expected in the stock due to some unforeseen circumstances, we can mitigate our losses by going short on stock.
- Portfolio Diversification
Despite hedging your losses, portfolio diversification is an important method that an investor should adopt to accomplish their long term financial goals while minimizing risks. By diversifying one’s portfolio, an investor ensures that they are not putting all their eggs in one basket i.e. not putting all the money in a single stock or industry.
Portfolio diversification means investing in various asset classes, i.e., Gold, International equity, etc. What is important is that the correlation between our groups of investments should be low.
For instance, the pandemic was especially brutal to the air travel industry. The share prices kept dropping following all the bad news around the lockdown and canceled flights. If an investors’ portfolio only had airline stocks, they would have gone through a noticeable loss. This loss could have been avoided if they had a portfolio comprising stocks from various sectors.
Additionally, having gold in our portfolio which has a lower correlation to other asset classes can help us diversify as well as a hedge against inflation. Even having exposure to international assets, such as the Nasdaq 100 ETF, can help us diversify the country-specific and currency risks.
A futures contract is the same as the common understanding of a legally binding agreement to buy or sell an asset at a pre-agreed price at a specified time. Thus, Futures contracts are standardized and traded on an exchange that a trader must sell at a specific time for a specific price.
A few strategies within this category include:
- Short hedges
In this, we go short on a futures contract. This is generally done when we have to sell an asset in the future / expect prices to go down.
For instance, if a trader has stocks of Reliance, and feels that the stock prices are likely to go down given any circumstance, they can hedge their lot by selling futures contracts.
- Long hedges
This is exactly the opposite of a short hedge wherein we take a long position as we wish to buy the asset in the future / expect that the price may rise.
For instance, if a trader has taken a short position in Reliance, and feels that the stock prices are likely to rise given any circumstance, they can hedge their lot by taking a long position.
There are mainly 2 types of options used in this strategy:
- Call Option: The call option is a type of options contract which gives the buyer the right, but not the obligation to exercise the option / buy the security at the strike price before the contract gets expired.
- Put Option – The put option is a type of options contract which gives the buyer the right, but not the obligation to sell the security at the strike price before the contract gets expired
Since we get a right to buy/sell without any obligations to do so, we have to pay a premium to the option seller.
A trader can:
- Buy put options to hedge the long stock/futures position
- Buy call options to hedge short stock/futures position
- Sell put options to hedge short stock/futures position
- Sell call options to hedge long stock/futures position
We hope that you are clear about the topic. But there is more to learn and explore when it comes to the stock market, and hence we bring you the important topics and areas that you should know:
Hedging does come at a cost but it is always advisable to hedge your portfolio no matter which strategy you adopt. It is not always possible to have a perfect hedge. We must properly assess the risks involved before investing and manage our risks properly.