As an investor, you learn is that investments are subject to market risk. As a novice, you may be cautious of associated losses. However, you may want to increase your capacity for risk increases; you may explore other opportunities and strategies. This is where hedging comes into the picture. In this article, we’ll explore what is hedging in finance and its advantages.
Hedging is a standard convention followed in the stock market. More simply, investors use different types of hedges to safeguard themselves from monetary losses that they might incur due to market fluctuation.
Let’s explore the meaning of hedging and what do hedge funds do. It is a handy practice of which every investor should be aware. In the stock market, hedging is a fundamental way to safeguard your investment portfolio. Even first-time investors can quickly learn the benefits of hedging techniques and use hedge funds to protect their investment portfolio. For investors, hedging serves as a risk management strategy to counterbalance potential losses in investments. Typically, hedging involves the use of derivatives, such as options and futures.
What Is Hedging?
If you’re new to investing or you’re new to the advantages of hedging, we’re here to break it down for you. Imagine you have an investment portfolio. Now, investment instruments such as stocks and bonds in your existing portfolio are subject to market volatility. Due to market risk, your investments may not always perform well, thereby fetching poor returns. Think of hedging as a way to ensure your investments.
Hedging in finance is a way of insuring yourself against a negative effect on your finances. While this does not imply that by hedging the negative impact will be avoided; however, you will be able to reduce the negative impact on your finances. In other words, hedging helps an investor minimise any losses he might encounter concerning his investment portfolio.
Investment portfolio managers, investors, and investment firms and corporations make use of hedging strategies to abbreviate their subjection to various market risks. While it may seem that hedging is just like the act of purchasing home insurance which secures you against burglary and fire damage, in financial markets such as the stock market, however, hedging is not quite as direct. Then, what is hedging in stock markets, you ask? Well, in the stock market, hedging against investment risk implies the tactical and judicious use of market strategies and financial instruments for offsetting the threat of any unfavourable price fluctuations. More importantly, investors hedge one investment by trading in another.
What do hedge funds do?
Hedging in finance is not a technique for generating a profit. Instead, the different types of hedges enable investors to reduce their potential loss. For instance, if the investment that an investor hedges make money, then he/she will have typically decreased the profit that could have been made from other investments. On the other hand, if the investment loses money, then the investor’s hedge fund, if successful, will bring down that loss.
If this confuses you, don’t worry. The example below will help clear things out. Let’s see what do hedge funds do with an example. Let’s say you own the shares of Company A that deals in textiles. However, currently, you’ve started getting a little worried about the chances of incurring some short-term losses in the textile industry. To safeguard yourself from the loss, you can purchase a put option on Company A. The put option is an investment derivate that provides you the right to sell the stocks of Company A that you hold, at a specific price, also called the strike price. If the stock price falls even below your strike price, your potential losses will be offset by your put option.
Here’s another example for more clarity on what is hedging in the stock market. Let us assume that Company B is engaged in the trade of grapes. If the prices of grapes were to shoot up, Company B would be at severe risk of losing its profits. To hedge itself against the unpredictability of grape prices, it can enter into a futures contract which will enable it to purchase grapes at a predetermined price and date in the future. This way, Company B will be able to protect itself against fluctuating commodity prices.
Risk is an integral part of investments, however, cautious you choose to be. Therefore, having a basic knowledge of hedging strategies will lead to better awareness of how companies work and how to protect yourself from market volatilities. Whether or not you decide to start practising the intricate uses of derivatives, learning about how hedging works will help advance your understanding of the market, which will always help you be a better investor.
To protect against risk, experienced investors choose from a range of hedging techniques. Now that you know of the advantages of hedging, it is time to safeguard and explore.