Think of hedging like insurance. Insurance doesn’t prevent something bad from happening, but, it does reduce the financial impact if and when it does.
Take car insurance for example, let’s say your car was damaged in an accident, the insurance you’ve been paying each month means that, in most cases, you will not be out of pocket when fixing or replacing your car.
Minimising your risk
Hedging is all about protecting your portfolio and minimising your risk. When you hedge, you are using the market to offset the risk of adverse price movements. Hedging is a specific practice in which traders use one of a variety of strategies to protect their profits. It’s about reducing losses not about making a profit.
The practice is used by all types of traders – portfolio managers, individual investors, corporations, etc. – however it usually takes traders some time to develop a strategy that works for them and their portfolio.
How to hedge?
There are lots of way to hedge against losses. Many traders use derivatives such as options, futures, and CFDs to offset their risk, whilst others may use the practice of diversification. Each method has its own benefits and risks for a trader, let’s dive a little deeper and discover more.
Put Options are used to allow a trader the option (choice) to buy or sell shares at a specific price at a future date. For example, you own shares of company C, which you think will do well in the long run but aren’t quite so confident about its near-future. To protect yourself from major losses, you buy a Put Option, which lets you sell shares of company C at a specific price. If the stock goes below this price, your losses will be reduced by the gains of the Put Option.
A futures contract is an obligation to buy a certain product, service, share, or really anything else, in future, on a specific date, with a price set today. Take this example. As the boss of company C, you’re worried about an essential ingredient, ingredient X, of your product increasing in volatility. This could affect your profits. To hedge against the volatility of ingredient X, you enter into a futures contract that allows you to buy ingredient X at a set price in the future. This means you won’t have to worry about price rises during this time. However, if the price falls you will still be liable to pay the difference, meaning you still risk losses.