What is double hedging?

When trading, it’s important to concentrate on strategies that could generate returns for a given risk. It is equally important to protect your portfolio from market uncertainties. 

Hedging is a risk management strategy that makes use of derivative instruments. Double hedging means employing futures and options contracts to enable portfolio protection against losses caused by changes in the cash prices of the underlying instrument.

Double hedging is a type of hedging that typically involves taking positions in the futures and options markets to limit overall exposure to risk in the cash or spot market. Futures and options contracts are categories of derivative instruments whose values are dependent on the value of an underlying asset. 

While a futures contract requires the parties to sell or buy an underlying asset for a pre-decided price on a fixed date, an option contract provides a choice to exercise the same buying or selling right without obligation. When an investor adopts a double hedging strategy, they are essentially doubling up on their efforts to ride any downtrend in the market.

When is a good time to double hedge?

A double hedge strategy is usually employed when hedging in either futures or options would mean insufficient liquidity. Regulatory limits can also trigger double hedge strategies, where executing a hedging strategy in only one market (of either futures or options) is beyond that particular market’s capacity. This is where traders could double up a market position by hedging in both futures and options. 

The Commodity Futures Trading Commission defines double hedging as “a situation where a trader holds a long position in the future market in excess of the speculative position limit as an offset to a fixed price sale, even though the trader has an ample supply of underlying commodity to meet all sales commitments.”

The speculative position limit implies the maximum position one can hold for an underlying asset’s futures or options contract.

Example of a double hedge

Suppose, your portfolio of assets is worth $5m and you wish to double hedge your position against a potential market downtrend. You may consider going long for a put option of $5m and shorting the same amount in the futures market. By taking these positions, you will be doubling up on your hedging for the same amount of portfolio exposure, if the prices of your assets go down in the future.