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Hedging for beginners: its purpose and benefits

by Samantha Greene / Jul 21, 2023 / 5m

The main aim of hedging in the world of finances is to create a proper defense for investments. The simplest definition of hedging in finance states that this method diminishes potential losses. No wonder you may be interested in hedging strategies because everyone wants to profit and not lose money. Let’s unveil the main secrets of this instrument as well as its utilization. 

What is hedging?

When you purchase some kind of insurance policy, that is the basic example of hedging. In the event of damage or an accident, your losses will be fully or partially covered by the insurance.

The same mechanics were introduced into the world of finance. To reduce various types of risks, both individual traders and large companies use hedging. Of course, hedge strategies cannot completely prevent all possible losses, but they can help diminish them. In addition, this instrument can be utilized to minimize the risks of price fluctuations for almost any physical or financial product:

  • Stocks, including individual stocks, portfolio, and indices
  • Ocean freight rates
  • Commodity prices
  • Currency rate exchange
  • Interest rates on loans and credits

Most businesses today use this modern instrument. Therefore, knowing the basic principles of a hedged investment is crucial for both individual users and large entities.

Advantages of hedging

Trade hedging has recently gained huge popularity, and many derivatives are used for it. The most common are:

  • Forwards;
  • Futures;
  • Options;
  • ETFs.

One of the most common options is hedging risks with futures. It is suitable for protection against market downturns and is widespread at the professional level. For instance, a trader can protect his portfolio from the so-called black swans. This is the common name for different unpredicted events that can happen on the market, including a financial crisis, a natural or human-made disaster, and so on. Such events lead to a significant decrease in pricing, and it is good to have a defense mechanism like hedging.

Investors prefer this method for different stock indexes. It works as proper protection for their portfolios from excessive volatility and drops in the market.

Diversification vs. hedging: understanding the differences

To learn the key differences between diversification and hedging, you need to know more about the common risks in the area of investments. When you purchase some shares, you are immediately taking on a risk. Moreover, there are two types of it: systematic and unsystematic. After the purchase of a stock, you are exposed to both of them. They become a reality when the prices for your item decrease.

The decline in pricing may be observed because of:

  • decrease in the company’s income;
  • diminished rate of profit;
  • high leverage;
  • misbehavior of the management system.

Possible reasons are numerous, and some of them are quite unpredictable. However, they all have one thing in common: they are all risks for a given company.

Let’s imagine an investment of $100,000 is made in Company A. After some time, its revenues declined. Then, the share price will also decrease. Thus, the investor inevitably loses some money on it.

However, some competitor in Company B will not experience any negative changes due to this situation. That is why the company-specific risks were true only for Company A. We call such types unsystematic risks.

It is possible to diversify them. This means that instead of investing all the funds in one company, one can select two or three different options, and it is better to select from different areas. In this case, unsystematic risk is diminished.

Now let’s imagine the situation of an investment of $50,000 in Company A and $50,000 in Company B. Under such circumstances, even if the pricing for one of them decreases due to unsystematic risk, only half of the sum will be damaged. That is the reason why seasoned investors create portfolios of 5, 10, or 20 stocks. The greater their number, the fuller the diversification and, therefore, the less unsystematic risk taken by the investor.

At this point, one can ask what the most suitable number of options is for a reliable portfolio. According to experts and pieces of research, up to 21 stocks deliver the desired effect and create a good amount of protection against unpredictable situations on the market. 

Still, there is a systematic risk that we haven’t yet discussed. They are also known as macroeconomic risks that affect the whole market. They are also quite various, but the most usual options include:

  • decrease in GDP growth;
  • inflation;
  • higher interest rates;
  • budget deficit;
  • geopolitical issues.

Such risks affect all positions on the market. Even a person with a well-diversified portfolio will experience the consequences, and it is a normal situation. However, what do we have to do? Is there a way to combat the losses in this case?

Well, systematic risks can be hedged with stock index futures. Thus, when we mention futures hedging, it is not equal to diversification. The latter technique minimizes unsystematic risk, while hedging is utilized to reduce the influence of systematic risks.

Numerous strategies for hedging exist and can be applied. A simple one involves the purchase of a portfolio of stocks and the sale of stock index future. More sophisticated approaches include additional hedging of futures with options or other derivatives.

Final thoughts and conclusions

Hedging is more common and popular nowadays among both individual investors and huge companies. To join this trend, one has to do the following:

  • study the instruments that are used for it;
  • learn more about the strategies, their benefits, and drawbacks;
  • use currency futures to diminish the risks;
  • apply modern trading platforms that help to gain basic knowledge and provide useful analytics.

Altogether, different types of insurance protect us against the usual risks, while futures hedging serves as a defense in the financial world. Utilize this tool to stay successful and always get your profits.