What Is Hedging?
Hedging is best understood as a sort of insurance. When individuals choose to hedge, they are protecting themselves against the financial consequences of an adverse event. This does not mean that all unpleasant events are prevented. However, if an adverse event occurs and you are adequately hedged, the event’s impact is mitigated.
Hedging occurs practically everywhere in practice. For Example, if you purchase homeowner’s insurance, you will be protecting yourself against unforeseen tragedies like robberies, fires etc.
Organisations, individual investors and portfolio managers often use hedging tactics to mitigate their exposure to various risks. On the other hand, Hedging is not as simple as paying an insurance firm a premium each year for coverage in the financial markets.
Hedging against investment risk is strategically employing financial instruments or market tactics to mitigate the risk of adverse price changes. In other words, investors protect one investment by hedging it with another.
Therefore, a risk reduction necessarily implies a loss in possible income. Thus, Hedging is primarily a tactic used to mitigate future loss (and not maximise potential gain). If the investment against which you are hedging earns money, you have typically lowered your potential profit as well. Whereas, if the investment loses money and your hedge is successful, you will have mitigated your loss.
Recognise Hedging
Generally, hedging tactics entail the use of financial products referred to as derivatives. Options and futures are the two most frequently traded derivatives. You can use derivatives to create trading strategies in which a gain in another compensates for a loss in one investment.
Hedging’s Disadvantages
Each hedging method entails a cost. Therefore, before deciding to utilise Hedging, you should consider whether the possible benefits outweigh the expenditure. Bear in mind that the purpose of Hedging is not to make money; it is to protect against losses. The hedging cost, whether it is the premium paid for an option–or the profit lost on the wrong side of a futures contract–cannot be avoided.
While it is tempting to make a comparison between Hedging and insurance, insurance is significantly more exact. Insurance ensures that you are fully reimbursed for any loss (usually minus a deductible). Portfolio hedging is not an exact science. Things are prone to go wrong. While risk managers are constantly striving for the optimal hedge, achieving it in practice is exceedingly challenging.
Hedging Techniques
Position with a long put
The most expensive option hedge is a long-put position. Typically, a strike price of 5 or 10% below the current market price is employed. These options are less expensive but do not protect the portfolio against the index’s first 5% or 10% loss.
Collar
A collar involves the sale of a call option and the purchase of a put. By selling a call option, you can cover a portion of the cost of the put option. The downside is that the upside will be limited. If the index climbs over the call option’s strike price, the call option will expire worthlessly. Portfolio gains will mitigate these losses.
Spread the word
A put spread is made up of two put positions, one long and one short. For instance, a portfolio manager can purchase a put with a strike price of 95% of the current market price and sell a put with an 85% strike. Again, the put sale will cover a portion of the cost of the purchased put. In this case, the portfolio would be hedged only if the market fell from 95% to 85% of the initial strike. If the spot price goes below the lower strike, the long put’s gains will offset the short put’s losses.
Fence
Fences are a hybrid of collars and put spreads. They involve purchasing a put with a strike price close below the current market level and also selling a put with a lower strike price and a call with a much higher strike price. As a result, a low-cost structure is created that mitigates some adverse risk while allowing for some gain.
Covered telephone call
In a covered call strategy, out-of-the-money call options are sold in conjunction with a long stock investment. This does not eliminate downside risk, but the premium received more than compensates for any losses. Typically, this method is applied to individual equities. If the stock price exceeds the strike price, the option position’s losses outweigh the equity position’s gains.
Now we’ll discuss several alternative methods for hedging equities that do not involve the use of options:
Diversification
The most effective strategy for long-term portfolio hedging is diversification. By diversifying a portfolio’s holdings with uncorrelated assets in addition to equities, overall volatility is minimised. Alternative assets often depreciate less in a down market, implying that a diversified portfolio will see fewer average losses.
In comparison to cash, alternative assets yield positive returns over time, implying that they are a less significant drain on performance. Due to their long and short positions, hedge funds can potentially create positive returns during a bad market. Catana Capital’s Data Intelligence Fund responds to changes in market sentiment using real-time data. Due to the fund’s rapid response to changing market circumstances and its exposure to both long and short positions, it works as a buffer against volatility and downside risk.
Keeping cash on hand
Maintaining a cash position is one method to mitigate volatility and downside risk. The less risky assets in a portfolio, such as shares, the less it can lose during a stock market meltdown. The trade-off is that cash yields little to no interest and depreciates in purchasing power due to inflation.
Selling stocks or futures on the short side
Shorting stocks or futures contracts is a cost-effective technique to protect equities from a short-term downturn. Selling and then repurchasing stocks can affect the stock price, although trading futures have negligible market influence. Selling a futures contract is a more cost-effective way to reduce your equity exposure.
