Hedging Strategy

A hedging strategy works like protection for an investment. It aims to reduce the effect of unfavourable price movements.

• Hedging can reduce investment risk.
• It does not remove risk completely.
• Futures and options can support hedging.
• Diversification can reduce portfolio-level risk.
• Hedging may also limit potential gains.
• Average down is not a direct hedge.
• Arbitrage is different from hedging.
• Every hedging method carries its own risks.

Hedging is a risk-management strategy that investors use to reduce possible losses. You take another position that can offset some of the loss if your main investment moves against you.

Think of hedging like insurance. You buy car insurance because an accident can cause a large financial loss. You pay for protection even though you may never need to use it.

Investments work differently from insurance, but the basic idea is similar.

For example, suppose you own an asset whose price may fall. You may take another position that benefits if the asset price falls. The gain from the second position can partly offset the loss on the first.

However, a hedge does not guarantee that you will avoid every loss. The hedge itself can also involve costs and risks.

Investors can choose a hedging strategy based on their portfolio, risk level, and investment objective.

Individual investors, fund managers, and portfolio managers can use hedging to manage investment risk.

Also read: Asset allocation

Hedging is not limited to the share market. Investors and traders can also use risk-management methods in areas such as commodities, currencies, and other securities.

Some commonly discussed approaches include diversification, average down, and arbitrage. However, these methods do not all work as direct hedges.

Diversification

Diversification means spreading your money across different investments instead of putting everything into one investment or sector.

For example, suppose you invest all your money in shares from one sector. A major problem in that sector can affect your entire portfolio.

Instead, you may spread your money across different sectors or asset classes. A fall in one part of the portfolio may then have less effect on the overall portfolio.

This is why diversification can help reduce risk.

However, diversification does not protect you from every type of market loss. It is a risk-management method rather than a direct hedge against a specific position.

Average down

Average down means buying more units or shares after their price falls. This reduces the average purchase price of the total holding.

For example, suppose you first buy a share at a higher price. The price later falls, and you buy more shares at the lower price. Your average purchase price then comes down.

However, average down is not a hedging strategy in the strict sense.

You are increasing your exposure to the same investment rather than taking an opposite position to reduce risk. If the price continues to fall, your losses can increase.

Arbitrage

Arbitrage involves trying to benefit from a price difference for the same or a related asset in different markets.

For example, if an asset is available at a lower price in one market and a higher price in another, a trader may try to buy at the lower price and sell at the higher price.

Arbitrage is not the same as hedging. Its main purpose is to benefit from a price difference rather than protect an existing investment from loss.

Futures and forward contracts, however, can directly support hedging.

1. Futures contract: A futures contract is a standardised agreement to buy or sell an underlying asset at a predetermined price on a future date.
2. Forward contract: A forward contract is an agreement between parties to buy or sell an asset at an agreed price on a future date. Currency and commodity exposures can be managed through suitable forward contracts.
3. Money markets: Money markets deal with short-term borrowing, lending, and financial instruments. They form part of financial risk management, but a money market itself is not a hedging contract like a future or forward.

Traders and investors can use different methods to manage risk. The method depends on the type of investment and the risk they want to reduce.

1. Asset allocation

Asset allocation means dividing your investments among different asset classes.

For example, instead of putting all your money into shares, you may spread investments across different types of assets. If one part of the portfolio performs poorly, another part may reduce the overall impact.

Asset allocation can therefore reduce concentration risk. However, it does not guarantee protection against losses.

2. Via options

An option gives its buyer a right, but not an obligation, to buy or sell an underlying asset at a fixed price according to the terms of the contract.

A call option gives the buyer the right to buy the underlying asset.

A put option gives the buyer the right to sell the underlying asset.

For example, suppose an investor already owns shares and is worried that their price may fall. The investor may buy a put option. If the share price falls sharply, the put option can help offset part of the loss.

You do not need to hold a long position in every situation to use options. The earlier claim that an investor must always hold a long position to use an option is incorrect.

Options also involve costs and risks. A hedge can reduce risk, but it cannot guarantee against all losses.

3. Debt and derivatives

Investors can hold different types of investments to spread risk across their portfolio.

Debt investments can behave differently from shares. However, debt investments also carry risks and should not be treated as automatically secure or risk-free.

Derivatives such as futures and options can be used to hedge certain positions. Their value depends on an underlying asset, such as shares, commodities, or currencies.

A trader should first understand which part of the portfolio faces risk. The trader can then decide whether a suitable hedge is available.

Hedging can offer several benefits when used for risk management:

• Limits the effect of losses: A suitable hedge can partly offset losses from an unfavourable price movement.
• Helps manage uncertainty: Hedging can make the effect of certain market movements more predictable.
• Supports portfolio risk management: Investors can use hedging alongside diversification and asset allocation.
• Protects specific positions: Futures, forwards, and options can be used to manage particular market risks.

However, hedging does not automatically increase profits.

A hedge can involve a cost. It may also reduce some of the gains if the original investment moves in your favour. The main purpose of hedging is to manage risk, not to maximise returns.

Also read: Capital asset pricing

A hedging strategy can help reduce the impact of unfavourable price movements on your investments. Investors can use tools such as futures, forwards, and options to manage specific risks.

Diversification and asset allocation can also reduce portfolio-level risk, but they are different from a direct hedge. Hedging does not remove every risk or guarantee profits. A suitable strategy depends on the investment, the risk involved, and the type of protection required.