What is hedging in trading?
A hedge is an investment position that is opened in order to offset potential losses of another investment. Think of hedging as an insurance on an investment: if an investor is hedged in the event of a sudden price reversal, then the ramifications are dampened. Simply put, a hedge is a risk management technique used to reduce any substantial losses. You hedge to protect your profit, especially in times of uncertainty.
An investor can construct a hedge from many different financial instruments ranging from stocks to exchange-traded funds (ETFs). For instance, gold mining stocks and gold ETFs are generally used to hedge against the wider stock market in times of poorer performance.
However, derivatives are used more commonly as a hedging method partly due to the fact that you can short-sell derivatives. For instance, an investor may have long-term holdings in various blue-chip stocks. In the expectation of a short but sharp downturn, they may use CFDs to hedge against this without having to liquidate their holdings. CFDs can be used to directly hedge against nearly all asset classes, like shares, commodities, forex pairs, indices and cryptocurrencies.
Perfect vs. imperfect hedging: hedging against risk
A perfect hedge is one that includes two equal but opposite positions in the market. In this case, gain and loss in one market are offset by gain and loss in the other. Consequently, the investors risk exposure will be eliminated. This may, at first, sound counterintuitive because the two opposing positions will simply offset one another, but it is more common than you think. Investors can use this kind of hedge in the instance discussed earlier when an investor has long-term holdings that they do not want to sell but are expecting a short price reversal. They construct their hedge as a perfect inverse to their holdings. In reality, this is hard to execute precisely, but the idea stands firm.
An imperfect hedge, on the other hand, is one that aims to partially offset a loss, so the exposure of the hedge is smaller than that of the opposing holding. This type of hedge is still effective but does not eliminate all risk; if set-up correctly, it aims to offset a large part of the loss. Imperfect hedges are used as precautions when an investor is unsure of the impact of any given market direction on their holdings.
For instance, imagine the same scenario as before, where an investor has long-term holdings, but this time, they are not sure how strong a dip will be or whether it will even occur at all. They know they could potentially still make profit with an imperfect hedge, and are willing to take some risk, but they do not want to risk a substantial loss if the market does take a turn for the worse. So they set up a hedge against their portfolio with less exposure. This way, if the market carries on rising, they have made some profit, but if the market drops, they have partially offset their loss.
The decision whether to use a perfect or imperfect hedge is crucial within risk management. If a sharp impending fall looks as if it’s almost certain to hit a market, then a perfect hedge is the better choice. However, if an investor can afford to take a slight risk, and are less certain of the chances of a price reversal, then an imperfect hedge is a better risk management strategy. Obviously, if someone were to know where the market was heading, then a hedge would be a hindrance on profit. But no one knows the direction of the market with certainty, and that is why hedges are an insurance policy. Risk management is essential to a trading strategy.
How do investors hedge using CFDs?
A contract for difference (CFD) is a popular type of derivative that allows you to trade on margin, providing you with greater exposure to global markets. When trading CFDs, you do not buy the underlying asset itself. Instead, you buy or sell units for a given financial instrument depending on whether you think the underlying price will rise or fall.
Once an investor has decided whether they are going to execute a perfect or imperfect hedge, they open a CFD position that opposes their holdings. You can directly hedge against your holdings buy purchasing opposing CFD contracts in the same markets. Alternatively, you can indirectly hedge against your holdings by opening a position that tends to be inversely correlated with your holdings, as in the instance of mining stocks in times of economic crisis. Note that if these positions move in the same direction, then it is not technically a hedge (in the strict sense of the term), and will amplify your losses.