Basics of Hedging – What is Hedging in Stock Market? |

By Trader Pit

July 7, 2021


If you are a stock trader and you are looking to hedge some of your investment, you have probably came across the term “hedging” a lot. What is hedging in stock market? Is it a good investment? Let’s find out.

Hedging is a strategy that helps you mitigate risks and the most common hedging instruments are options. In this article, we will talk about the basics of hedging and the different types of hedging instruments.

Hedging is a technique used by various investors to protect their portfolio by gaining temporary exposure to the opposite side of the market. This way, an investor can put his portfolio into ‘cold storage’, waiting for the market to fall to a certain level before buying back his portfolio. A simple way to understand hedging is that it is a temporary protective way of owning an asset.. Read more about what is hedging in trading and let us know what you think.Understand the basics of hedging and how to use it to reduce equity market riskIf you are a capital market investor, you probably have days when your portfolio goes wildly up or down. Stock market fluctuations are always a source of anxiety and stress for investors. Although experts recommend ignoring these fluctuations, it’s hard for a layman to look the other way when things go wrong. It’s easy to obsess when things go wrong.

In these times, many of us wish there was a way to insure our investments in the event of a recession, just like we insure other assets, like a car or a house. Hopefully there is some sort of agreement that we will be compensated if something bad happens. In this case, a significant monetary loss of the size of our investment due to a factor completely out of our control.

To be fair, such a thing exists in the real world too, but it’s called something else: coverage. When we hedge investments, we reduce or eliminate certain risks, including, but not limited to, declines in the general stock market. This is a popular practice in investment management, and some funds, known as hedge funds, even offer such investments that allow investors to completely eliminate certain types of risk.

Although most hedge funds generally underperform the overall market, the temptation to avoid certain known risks in their portfolios has not stopped large and wealthy investors from pulling out their wallets to invest in these hedge funds.

But watch out for the buyer! While they are very useful for protecting your investments in the event of a collapse, a poorly managed hedge or hedge fund can cause investors to lose more money than if they had taken all the risk themselves. In today’s article, we will learn more about hedging and its advantages and disadvantages.

Roofing principles – What is roofing?

When you hear the word hedge, you probably think of your neighbor trimming his bushes in the garden. But the name actually comes from an older meaning of the word. A hedge is actually synonymous with a fence, as we try to contain a herd of cows or perhaps limit our investment in a limited space.

Although this term is now commonly used to describe financial strategies, we apply its principles in practice every day. As mentioned earlier, auto insurance protects your financial risk because you pay a premium to avoid the high costs you might incur in a car accident. Although seat belts can reduce the risk of serious injury. Shit! That’s what you do when you set your watch to leave for work ten minutes early (you insure yourself against being late).

In both cases, you accept certain costs or inconveniences in order to avoid or prevent a major financial or other problem. However, investing is about reducing one risk or another in our portfolio. This may be the downside risk of a particular stock or sector, the risk of rising interest rates, or sometimes the risk of higher than expected inflation.

How does a hedge work and how is it used?

Hedging is done by adding assets to our portfolio that move in the opposite direction of the risk we are trying to manage.  Mathematically, we are trying to get a correlation of with a commitment of -1 , although technically we are looking for what knowledgeable quants would call a negative delta.

Negative delta is simply a measure of how an asset changes when the price of another asset changes by one unit. This ensures that if a risky event occurs and our assets decline in value, the hedge we have invested in would have to increase in value to offset the loss.

A simplified example: an investor can hedge his position in a certain stock by going short in that same position. In this way, they balance their negatives. If the value of the stock falls, the value of the short position rises, offsetting the loss.

Today, investors rarely choose a perfect hedge, because after all, you’ve protected yourself from a downturn, but you’ve also prevented the portfolio from making a profit. This alone may convince you that this is not the wisest investment decision on the market.

So instead of defending against every downward market move, smart investors focus on defending against only certain risks in a way that doesn’t completely eliminate the possibility of growth, but still protects them from losses they don’t want to incur.

Take for example an Indian mutual fund that invests in stocks in the US stock market. Any investor who invests in foreign equities is by default exposed to the risk of different interest rates, inflation rates and exchange rates between the two countries.

Since interest rate and inflation differentials are generally reflected in the currency, an investor may choose to purchase certain assets that increase in value when exchange rates fall. With this particular program, they can now get a return similar to what they would get if they invested as Americans.

How to do intraday trading for beginners in India?

What are the most common investments/instruments used for hedging?

While it is technically possible to hedge a portfolio through traditional methods such as diversification or investment in alternative assets, explicit market hedging is done through extensive use of instruments known as derivatives.

Broadly speaking, a derivative is simply a contract in which you, the investor, make a bet or agreement with another investor to buy or sell an asset at a fixed price in the future.

There are many interesting things you can do with derivatives. For example, at the time of writing, the market is significantly overvalued and there is a lot of uncertainty about the budget in the coming weeks. An investor who owns shares could, in theory, buy a put option that expires in two or three weeks at a premium paid in advance and thus protect himself against a market decline while making a profit on his shares.

While these tactics seem very simple, many may be surprised to learn that these are the same strategies hedge funds use for their high net worth clients. Among other things, hedge funds often use derivatives to take long positions in some assets and short positions in others, in order to make a profit regardless of market conditions.

What are the disadvantages of coverage?

Industry experts may say that hedging is some kind of holy grail of investing, but the truth is that hedging is not without its drawbacks.

First, hedging usually requires an initial investment that is lost when the market rises. This is a factor that nibbles away at your returns in a rising or sideways market, and the possible result is that it becomes much harder for you as an investor to outperform the benchmark over the long term.

Second: Hedging is an imperfect science. Professionals in the industry can tell you that this is an activity that requires a lot of skill and experience. But frankly, they would also agree that hedging is ultimately a reasonable assumption based on probabilities.

 

Short note
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Third: Even if you have coverage, it may not protect you. Suppose you have bought a put option (an option that offers downside protection) to hedge your investment if an asset falls by 10%. If the market falls by 8% on the expiration date, the option becomes worthless and your investment in purchasing the hedge is completely lost.

Because of these factors, many conservative fund managers prefer to avoid complex hedges and focus more on long-term gains than short-term losses. If you’re a long-term investor, they say, short-term stock market crashes are just an opportunity to buy more shares in your estate, so there’s no reason to spend extra money on a crash that may or may not happen.

Basis of insurance – significant findings

In this post, we discussed the basics of hedging and how investors can use it. While hedge funds are not available to many individuals, investors can theoretically employ the same strategies, but the effectiveness of their portfolios may depend largely on an individual’s ability to make active decisions and evaluate the market.

Therefore, any investor who wants to be active in the markets would do well to familiarize themselves with the hedging concepts learned before applying them. As difficult as it may seem, the fruits of this labor have rewarded market participants with tremendous wealth and success.

Levin is a former investment banker and hedge fund analyst. He is a graduate of NIT Warangal and has about 5 years of experience in the stock market.Hedge is any financial contract that reduces the risks of a position but increases the potential rewards. There are various ways to execute a hedge. A futures contract, for example, is a hedge to a specific commodity, such as oil, in which the buyer has the option to purchase or sell a specified amount at a specified future date. When buying a futures contract, the hedge represents the purchase of the underlying commodity. When selling a futures contract, the hedge represents the sale of the underlying commodity.. Read more about hedging meaning with example and let us know what you think.

Frequently Asked Questions

How do you hedge a stock?

A hedge is a financial instrument that is used to offset the risk of an investment.

What are the 3 common hedging strategies?

1. Buying an insurance policy 2. Selling an insurance policy 3. Buying a put option 1. Buying a put option

What is hedging and types of hedging?

Hedging is a way to reduce risk in an investment. It is a strategy used by investors to protect their investment by buying and selling an asset or a financial instrument in order to reduce the risk of a price change. Types of hedging: 1. Forward hedging 2. Backward hedging 3. Options 4. Futures 5. Swaps

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About the author

Trader Pit

A yogi who like Finance and Technology. I have been in Indian Stock market for over 12 years now as financial analyst, portfolio manager, trader. Now, I focus on Yoga, Financial Education & Long term investing. 

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