What Is Hedging and How It Works ?
Investment and financial instruments have associated risks. Traders and investors are always searching for the assets with the lowest associated risk and highest profits. Unfortunately, the former scenario is unusual. However, some protecting mechanisms exits to decrease the risk and limit the losses when something goes wrong; Hedging is one of that mechanism.
What is Hedging?
Hedging is a risk management strategy for limiting losses beyond the desired investor’s level. It protects the invested capital from an adverse situation, which will produce that it loses its value or the investor loses all the invested money as a consequence of assets sharply price decreased. Therefore, hedging minimizes the odds of your assets lose value.
Hedging is not insurance, but it has the same principle of covering you from unexpected losses. To have a better idea, imagine you buy 100 Shares for 10 USD from I corporation, expecting its price will rise at its maturity time, but I corporation’s shares fall and enter a fast downtrend making its shares’ prices go below the 5 USD. The former scenario could be bad, and the investor could lose from 50% of its investment to more if he is unable to sale it before price keeps falling. On the other hand, here the hedging can help, let’s Imagine the same scenario but the investor used hedging. He pays a premium for his right to sell his assets at or before its maturity time at a fixed amount. If the price drops below his buying price, let’s assume a 10% loss, he will sell it at 9 USD no matter how much the price drops.
Therefore, using the same scenario the investor had two options, on one hand, he could lose 500 USD or more, representing 50% of its investment. On the contrary, if he used hedging and bought it for his investment and set the minimum sale price at 10 USD after the price fell below the 5 USD per share, he sold his shares at 10 USD losing the hedging fee, which was disclosed before he bought it and accepted.
Different types of hedging:
The hedging technique can be used in diverse scenarios and for virtually any investment and financial options.
Hedging in Binary Options TradingInvestor can select to use hedging for his buys options, either calls or puts, by doing it, if the options end out of the money. He does not lose all the invested money. Additionally, he can sell his entry or option earlier than its maturity time, if he thinks the price will be opposite than anticipated. In both cases, the investor only pays a percentage of the total amount and recovers part of his invested funds. However, if the options end in the money at its maturity time, the investor pays a fraction of his profits to the hedge issuer.
FOREX hedge or foreign exchange hedge due to the high market volatility. A Forex trader or investor can select to hedge his trading risk with a financial institution.It sets the current exchange rate as the minimum selling price at maturity time, by doing this the trader prevents losing money if the exchange rate is adverse in the future.
Hedging in the stock market is offsetting the risk by investing in two different securities with strong negative correlation, to protect the investment from any adverse price variation. E.g., buying shares from company Y and Z with have a strong negative correlation if the price of one share drops the other rises.
Natural hedgeis the investment in two different assets, which performance of one cancels the other.
Hedging in saving is buying assets with will increase its value over time protecting the initial amount saved from devaluation and inflation. E.g., instead of saving 100000 USD on a bank account with interest, the investor will buy the same amount ofmoney in gold; at the expected time the gold price will be higher than the inflation, or devaluation, by doing this the investor keeps his investment value over time.
A hedge fund is an investing fund funded with the money from several investors, which is invested in several low-risk assets and generate profits for all the investor accordingly to their investment participation size. A hedge fund manager manages the hedge fund he is paid for doing it.
Derivative is a security with market price depends on several assets.
Hedge derivatives are securities, futures, and/or commodities with relation to the principal asset (investor shares’ selection) is known and if the price of one goes down the other goes up.
Hedge Options are the investment in which minimum price at maturity is established to be the buying price.
Futures is the term used to describe the ability to buy a crop or the future production of any good at a preset price. e.g., buying oil at 40 USD per barrel to be delivered next winter, or buying corn a 100 USD per ton for the next year.
Married put is when the trader buys option and simultaneously as a protective mechanism or a way of insuring his investment and lowering his risk; he buys the same amount of underlying stocks.
Option put is when the investor has the right to sell his assets at a particular price at the maturity time or before it. It guaranteed the investor would save his investment if the assets’ price falls.
Strike price is the fixed price at which the seller is willing to sell his assets, additionally, in binary options a strike price is a price at which a put or call option can be exercised.
In a nutshell, Hedging is a way to ensure that investment money will not be lost. The investor will either receive the investment plus its profits when he is right at the assets selection, and future its price at its maturity or the investor will recover the invested money if his price anticipation is wrong and the price move in an adverse direction. There are several types of hedging and various technique to do it. All of them work similar to an insurance policy with will cover some of your lose.