3 min
26-August-2024
Hedging is a crucial financial strategy that helps investors and traders reduce their exposure to different risks. In a hedge, investors try to offset the risk associated with a particular investment by taking a position opposite to it. Essentially, they aim to balance potential losses in one investment with gains in another.
In this article, we will understand what is hedging, hedge’s meaning, how it works, its downsides, and some widely used techniques of hedging.
Simply put, a hedge can be used as a kind of insurance policy, which helps you make up for any sudden or extreme losses in any of your other investments.
Investors use hedges as an investment strategy to attain diversification in their portfolios. For example, an investor may buy safe and conservative government bonds to offset any potential losses their investment in high-risk equities could cause.
In the world of stock trading, traders are always buying and selling high-risk high-reward shares. To manage these risks, they typically use derivatives for hedging. Derivatives are particularly useful because their values are directly tied to the underlying assets, providing a clear and effective means of risk mitigation.
Similarly, hedging does not eliminate the chances of you making a loss on an investment, but it does reduce the impact the loss can have on your financials when the markets are in a state of flux.
Another scenario could involve you investing in some of the best blue-chip IT companies because your research says that the sector is poised to do well in the next few quarters. But to hedge this investment, you might also invest in healthcare or consumer staples businesses, just in case your earlier investment does not perform up to the mark.
Another important thing to note is that hedging does not happen free of cost. In the case of insurance, you have to pay a premium at regular intervals in time to have that extra layer of protection. And if you never need to use the insurance, you will get nothing after the insurance period is over.
In the financial world, hedging works similarly. Financial experts, investors, traders, and money managers apply the practice of hedging to minimise their losses and reduce their exposure to different market risks.
Derivatives derive their usefulness and effectiveness from their delta, also referred to as a hedge ratio. This delta is defined as how much the price of a derivative is expected to change for every change in the price of its underlying asset.
The choice of a hedging strategy and the cost of hedging tools are primarily influenced by the potential downside risk of the underlying asset that the investor wants to protect. As a rule of thumb, the more downside risk of an investment there is, the more cost of hedging will be. As the volatility of an investment increases with time, so does the downside risk associated with it.
Generally, a put option with a higher strike price will cost more but provide better protection against price drops. You can adjust these factors to choose a less expensive option with less protection or a pricier one with more protection, depending on your needs.
For example, let us assume Mr. A buys 100 shares of a company at the price of Rs. 750 per share. Now, he has the option to hedge this investment by purchasing a put option, which allows him a strike price of Rs. 600, which will expire in the course of a year. By buying this put option, Mr. A now gets the right to sell these 100 shares of the company at the price of Rs. 600 whenever he wishes before the next year.
Now, he will also have to pay a premium for the put option, whose price, let us assume, is Rs. 80 per share, which translates to Rs. 8,000 for 100 shares. Now, if the share starts trading for Rs. 900, Mr. A will not need to exercise his put option and his payment of Rs. 8,000 will not be recovered. However, this does not turn out to be a loss-making deal for him since he has already covered the cost of the put option through his unrealised gains due to the price movement of the share.
However, due to an extreme market fluctuation, if the stock starts trading at Rs. 0, then the following will occur:
Total investment + cost of the put option = Rs. 75,000 + Rs. 8,000 = Rs. 83,000
Net loss calculation:
Mr. A makes a loss of Rs. 23,000 on this investment. If Mr. A had not bought the put option, he would have ended up losing his entire investment.
Let us take the example of Mrs. B, who is bullish on the growth of luxury brands in India and hence decides to invest in them, given their high margins. However, there are a few risks involved with this investment, such as a sudden crash or a recession that ends up eliminating the demand for lavish goods and luxury spending. So, to hedge this investment, Mrs. B will also invest in consumer staples stocks or utility stocks since these categories can withstand recessions and pay good dividends.
However, this strategy requires the investor to make a tradeoff. If people's incomes are on an upward trajectory and the job market is seeing positive growth, then luxury goods will be in demand. Only a few investors at this point would want to invest in countercyclical and boring stocks like staples and utilities. As a result, the prices of these stocks can fall a bit as capital moves to more happening sectors.
But this approach also has a risk. There is no sure-shot way of predicting that if the stock price of luxury goods falls, the hedge in the form of staples and utility will always move in the opposite (upward) direction. A global event like the financial crisis of 2008 can lead to the collapse of all the share prices for a short to medium-term period.
In this type of strategy, an investor buys a put option, which has a higher strike price and sells a put option, which has a lower strike price, both expiring on the same date. This approach allows the investor to limit potential losses while potentially earning a profit if the price of the underlying asset falls.
Now, depending on the movement of the index, the investor has a certain degree of protection, which is the difference between the two strike prices. However, this is not a comprehensive protection and can only be useful and sufficient during brief periods of market fluctuations.
Explore these related articles to deepen your understanding and make informed investment decisions:
However, multinational companies and fund houses widely use hedging as a tool. Many investors would be invested in funds handled by such companies. Hence, it is important to have a basic understanding of these concepts and see how hedging is used by large market players to minimise losses and protect the capital of their investors.
For those looking to optimise their mutual fund investment strategies, including hedging and diversification, the Bajaj Finserv Mutual Fund Platform can be your investment ally. It allows you to compare various mutual funds, helping you make informed decisions and invest wisely.
In this article, we will understand what is hedging, hedge’s meaning, how it works, its downsides, and some widely used techniques of hedging.
What is a hedge?
A hedge is a strategy in which an investment is selected with the specific purpose of reducing the chance of loss on any other investment if the price of the latter moves in the opposite direction.Simply put, a hedge can be used as a kind of insurance policy, which helps you make up for any sudden or extreme losses in any of your other investments.
Investors use hedges as an investment strategy to attain diversification in their portfolios. For example, an investor may buy safe and conservative government bonds to offset any potential losses their investment in high-risk equities could cause.
In the world of stock trading, traders are always buying and selling high-risk high-reward shares. To manage these risks, they typically use derivatives for hedging. Derivatives are particularly useful because their values are directly tied to the underlying assets, providing a clear and effective means of risk mitigation.
How does hedging work?
Hedging your investments is similar to having an insurance plan for yourself or wearing a seat belt while driving. If, in an unfortunate situation, you end up in an accident, the seatbelt will reduce the risk of you getting seriously injured, but won’t prevent the accident.Similarly, hedging does not eliminate the chances of you making a loss on an investment, but it does reduce the impact the loss can have on your financials when the markets are in a state of flux.
Another scenario could involve you investing in some of the best blue-chip IT companies because your research says that the sector is poised to do well in the next few quarters. But to hedge this investment, you might also invest in healthcare or consumer staples businesses, just in case your earlier investment does not perform up to the mark.
The downside of a hedge
Hedging involves a balance between risk and reward. While it helps in reducing potential losses, it also limits the amount of profit you can make. This tradeoff means that while you are protecting yourself from big risks, you are also giving up some of the potential gains you might have achieved without hedging.Another important thing to note is that hedging does not happen free of cost. In the case of insurance, you have to pay a premium at regular intervals in time to have that extra layer of protection. And if you never need to use the insurance, you will get nothing after the insurance period is over.
In the financial world, hedging works similarly. Financial experts, investors, traders, and money managers apply the practice of hedging to minimise their losses and reduce their exposure to different market risks.
Hedging with derivatives
Derivatives are financial instruments that derive their value from the price of an underlying asset. Some widely used types of derivatives are forwards, futures, and options.Derivatives derive their usefulness and effectiveness from their delta, also referred to as a hedge ratio. This delta is defined as how much the price of a derivative is expected to change for every change in the price of its underlying asset.
The choice of a hedging strategy and the cost of hedging tools are primarily influenced by the potential downside risk of the underlying asset that the investor wants to protect. As a rule of thumb, the more downside risk of an investment there is, the more cost of hedging will be. As the volatility of an investment increases with time, so does the downside risk associated with it.
Generally, a put option with a higher strike price will cost more but provide better protection against price drops. You can adjust these factors to choose a less expensive option with less protection or a pricier one with more protection, depending on your needs.
Example of hedging
The most widely used way of hedging in the financial world is by using put options. By exercising put options, the investor or holder gets the right but is not obliged to sell the security they are holding at a pre-determined rate and time or anytime before the date expires.For example, let us assume Mr. A buys 100 shares of a company at the price of Rs. 750 per share. Now, he has the option to hedge this investment by purchasing a put option, which allows him a strike price of Rs. 600, which will expire in the course of a year. By buying this put option, Mr. A now gets the right to sell these 100 shares of the company at the price of Rs. 600 whenever he wishes before the next year.
Now, he will also have to pay a premium for the put option, whose price, let us assume, is Rs. 80 per share, which translates to Rs. 8,000 for 100 shares. Now, if the share starts trading for Rs. 900, Mr. A will not need to exercise his put option and his payment of Rs. 8,000 will not be recovered. However, this does not turn out to be a loss-making deal for him since he has already covered the cost of the put option through his unrealised gains due to the price movement of the share.
However, due to an extreme market fluctuation, if the stock starts trading at Rs. 0, then the following will occur:
- Mr. A exercises the put option and sells the shares for Rs. 600 per share.
- Total amount received from selling = 100 shares × Rs. 600 = Rs. 60,000
Total investment + cost of the put option = Rs. 75,000 + Rs. 8,000 = Rs. 83,000
Net loss calculation:
- Total cost (investment + option) = Rs. 83,000
- Amount received from sale = Rs. 60,000
Mr. A makes a loss of Rs. 23,000 on this investment. If Mr. A had not bought the put option, he would have ended up losing his entire investment.
Hedging through diversification
Opting for diversification in your portfolio is also considered a good way to hedge your investments.Let us take the example of Mrs. B, who is bullish on the growth of luxury brands in India and hence decides to invest in them, given their high margins. However, there are a few risks involved with this investment, such as a sudden crash or a recession that ends up eliminating the demand for lavish goods and luxury spending. So, to hedge this investment, Mrs. B will also invest in consumer staples stocks or utility stocks since these categories can withstand recessions and pay good dividends.
However, this strategy requires the investor to make a tradeoff. If people's incomes are on an upward trajectory and the job market is seeing positive growth, then luxury goods will be in demand. Only a few investors at this point would want to invest in countercyclical and boring stocks like staples and utilities. As a result, the prices of these stocks can fall a bit as capital moves to more happening sectors.
But this approach also has a risk. There is no sure-shot way of predicting that if the stock price of luxury goods falls, the hedge in the form of staples and utility will always move in the opposite (upward) direction. A global event like the financial crisis of 2008 can lead to the collapse of all the share prices for a short to medium-term period.
Spread hedging
Investors who are more involved with index funds see a moderate decrease in the price of the index quite commonly but these trends are not predictable. So, the focus of the investor here is to have a hedge for these moderate decline market cycles rather than prepare for the more extreme ones. This is where the spread hedging strategy comes into play.In this type of strategy, an investor buys a put option, which has a higher strike price and sells a put option, which has a lower strike price, both expiring on the same date. This approach allows the investor to limit potential losses while potentially earning a profit if the price of the underlying asset falls.
Now, depending on the movement of the index, the investor has a certain degree of protection, which is the difference between the two strike prices. However, this is not a comprehensive protection and can only be useful and sufficient during brief periods of market fluctuations.
Explore these related articles to deepen your understanding and make informed investment decisions:
Hedging and the everyday investor
Investors who are in the market for the long term, like those saving for retirement or planning a college fund for their toddlers, do not necessarily need derivative contracts since they are unaffected by the frequent fluctuations of the market. Long-term investors who buy and hold do not require any protection in the form of hedging.However, multinational companies and fund houses widely use hedging as a tool. Many investors would be invested in funds handled by such companies. Hence, it is important to have a basic understanding of these concepts and see how hedging is used by large market players to minimise losses and protect the capital of their investors.
What is hedging against risk?
Hedging is a popular strategy used globally to minimise the risk of investing. Money managers, investors, and fund managers try to hedge a particular investment by buying or trading with another instrument or security that has the potential to move in the opposite direction than their initial investment.Key takeaways
- Hedging is used as an investment strategy that aims to reduce, offset or limit the risk of an investment.
- One of the most commonly used techniques of hedging is buying derivatives.
- Diversification of a portfolio is also a commonly used hedge, which invests in both a stock that is cyclical and the opposite, which is countercyclical.
Conclusion
Hedging is a vital investment strategy designed to mitigate risk and protect against potential losses. Whether through derivatives, diversification, or specific hedging strategies like spread hedging, investors aim to safeguard their portfolios against unpredictable market movements. By carefully balancing risk and reward, investors can manage uncertainties and stabilise their financial positions.For those looking to optimise their mutual fund investment strategies, including hedging and diversification, the Bajaj Finserv Mutual Fund Platform can be your investment ally. It allows you to compare various mutual funds, helping you make informed decisions and invest wisely.
