What is Hedging in Finance?

Hedging is a risk management technique used in finance and trading to protect an investment or a portfolio from unwanted risk. Hedging can be used to reduce the risk associated with adverse price changes, interest rates, exchange rates, and commodity prices. There are many different types of hedging strategies, each with its own advantages and disadvantages. Let's now dive a bit deeper into what hedging is, why it is used and how it works. We will also look at some common hedging strategies and their risks and benefits.

Hedging in Simple Words

Hedging is most commonly explained in association with insurance. When you travel abroad you usually buy travel insurance in order to avoid big expenses in case something unexpected happens and you need medical assistance that can be costly. You invest in insurance to protect yourself from even bigger financial losses. In a similar manner, hedging in finance is practiced as a measure of caution - an investment made not for making a profit but for avoiding a loss. Although very similar to insurance, hedging is much more complex and needs to be considered from various perspectives. 

Why is it Used?

No matter if you're a beginner investor or an experienced one, you should be aware of hedging as a risk management strategy. It's a way to protect your portfolio and reduce the impact of a negative event that might happen in the financial market. Hedging doesn't prevent negative events to happen but rather decreases the negative consequences of it on your portfolio. 

How Hedging Works

Hedging works by taking a position in one or more financial instruments that will generate profits if the original investment loses value. This way, should the initial position suffer losses, the hedging instrument can be used to offset those losses and reduce their impact. For example, an investor may purchase a put option on a stock they own, which will make money if the stock decreases in value. By hedging their position, the investor is able to reduce any potential losses that may occur due to market downturns or unfavorable developments in the industry or sector. 

Hedging can also be used to protect profits by taking a short position in a different financial instrument that has an inverse relationship with the original investment. For instance, an investor could purchase a call option on a stock they own if they believe the price will increase and then hedge their position by taking a short position in another financial instrument that would profit if the stock decreases in value. This approach can provide protection against losses should the stock unexpectedly decrease in price.

One very common example of hedging is related to companies that depend on a certain commodity. For example, the profit of an airline company that depends on fuel can be seriously reduced if the price of fuel goes up. In order to avoid buying fuel at a high price, the company may enter into a futures contract. This would allow the company to buy fuel at a specific price at a set date in the future. In this sense, futures contracts are used as a hedging instrument. It protects the airline company from buying the commodity it depends on at an unfavorable price. In case of a huge increase in fuel price, the company would profit from this contract. However, if the fuel price goes below the one specified in the futures contract, the hedging move wouldn't pay off since the airline company would still have to pay at the price specified in the contract. 

Which Financial Instruments Can be Used for Hedging?

Hedging usually involves using derivatives in relationship with their underlying assets. Options, futures contracts, forward contracts, and swaps are the most commonly used derivatives. They can be used to hedge against the underlying assets which might include stocks, bonds, commodities, currencies, indexes, or interest rates. What hedgers do is basically create a trading strategy where a loss on one investment is compensated or offset by a gain on a related derivative. 

Hedging Strategies

The most common strategies include:

1. Long/short hedging – taking a long position in one financial instrument and a short position in another that is related to the first

2. Futures and forward contracts – buying or selling futures with pre-determined dates at predetermined prices

3. Options trading - purchasing a call option and a put option on the same underlying asset

4. Currency swaps – exchanging one currency for another at an agreed-upon rate

5. Over-the-counter derivatives – using customized derivative instruments to hedge specific risks

6. Collars – combining stock purchases with protective puts and covered calls

7. Spreads – purchasing options at different strike prices to manage risk

8. Stop-loss orders – placing orders with brokers to limit losses if the security drops below a certain price

Each of these strategies has its own advantages and disadvantages, so investors should carefully consider which strategy is most suitable for their particular situation. Let's have a look at a couple of these strategies in more detail. 

Hedging With Put Options

Hedging with a put option is an effective way to protect against potential losses caused by unfavorable market movements. A put option gives the holder the right (but not the obligation) to sell an asset at a predetermined price within the put option expiry date, regardless of what the actual price of that asset may be in the future. 

For example, if an investor buys 100 shares of a company at the unit price of $20 and is worried about the stock’s price dropping, they can buy a put option on those 100 shares with a strike price of $17 expiring in 18 months. This would give them the right to sell their 100 shares at the predetermined price, called the strike price, at any time during these 18 months, no matter what the market price of the stock may be at a later date. 

Spread as a Hedging Strategy

This technique, also known as bear put spread, is commonly used by index investors. This is how it works: first, the investor buys a put with a higher strike price. Then, they sell a put that has a lower strike price but the same expiration date. The difference between these two strike prices is basically the protection against unpredicted index behavior. 

Diversification as a Hedging Technique

Besides using derivatives, diversification is another way of hedging, where investors spread their risk across different assets. This means that instead of investing all their money in a single stock or asset class, they will diversify into other types of investments to reduce the overall risk associated with any one particular investment. 

While diversification can help to reduce the potential for losses due to market volatility, it does not guarantee that investors will make a profit in any particular situation. Additionally, it is important to remember that diversification across asset classes can still be subject to a risk associated with those specific asset classes. Therefore, investors should still conduct their own research and ensure they understand what they are investing in before making any decisions.

Who Should Hedge?

Hedging is definitely recommended for and practiced by big corporations and investment funds that can use it to manage risk in effective way. On the other hand, individual investors, especially those dealing with long-term investments, are not interested in short-term price fluctuations as these can't really influence their final goals. For that reason, they might never use hedging in their trading. However, anyone involved in investing and trading should be aware of and understand at least the basics of hedging since it can help understand and analyze financial markets. 

Hedging in Crypto Trading

Crypto trading, just like any other type of trading, has its own risks. Usually, crypto markets are even more volatile than other markets with the coin prices changing sharply and unexpectedly. While this makes profit opportunities, it also creates a risk of loss. That's why hedging is applied in cryptocurrency markets as well. 

Almost all hedging strategies previously mentioned can be applied in crypto trading, although some may work better than others. For example, in a crypto-only portfolio, it might be quite difficult to successfully apply diversification since the prices of most cryptocurrencies are heavily dependent on Bitcoin and they tend to move in the same direction. 

What comes in really handy are automatic crypto trading platforms such as CryptoCortex with MarketMaker incorporated, with a highly customizable hedge logic configurator. It lets traders define specific conditions at which auto-hedging would be triggered. Some of the parameters that can be specified include:

• hedging instruments

• list of exchanges to execute hedge order

• hedge strategy

Advantages and Disadvantages of Hedging

Although the advantages of hedging are probably quite clear so far, let us sum them up here once again:

• Risk management - as the main benefit of hedging, it helps mitigate risk and ensure profitable trades.

• Loss reduction - although a hedge can't prevent unfavorable price changes, it can decrease their negative effects by reducing or even avoiding any loss.

• Commodity price clarity - using some types of derivatives, certain commodity prices can be determined in advance and be independent of potential adverse price movements.

Although all the benefits hedging has might sound alluring, you should also be aware of the disadvantages and the risks hedging brings as well. Here are the main ones:

• Hedge costs - hedging doesn't come free of charge. The price you pay may be in the form of the derivatives you buy to reduce risk exposure or in the form of the transaction cost or finally as the profit that you've missed due to the wrong judgment.

• Missed profits - if the market turns in a direction that the hedger had not anticipated, potential financial gain is missed.

• Misleading analysis - if you base your hedging strategy on the wrong premises and expectations, a hedge you place that seems to be the perfect investment might turn out to cause more losses than having no hedge at all.

Can You De-Hedge?

Yes. If you decide that you no longer need a hedge or that it's too expensive so it doesn't pay off, you can remove the position that was initially set to act as a hedge against a primary position that you have in the market. You can de-hedge all at once, in a single trade, or choose to remove the hedge step by step leaving the primary position partially hedged.

What Are Hedge Funds?

Hedge funds, named after the practice of 'hedging out' risk, serve a similar purpose to the hedging strategies mentioned earlier. They pool investor funds to apply various risk-reducing strategies across diverse assets. Managed by professionals, they follow strategies like taking both long and short positions or using derivatives, mirroring the conventional hedging approaches. However, their accessibility is typically reserved for sophisticated investors due to their higher fee structure.

So What is Hedging? - Bottom Line

A hedge is an investment used in financial markets in order to reduce the negative effects of unfavorable price movements on the stock market. Most often it involves buying derivatives, usually options and futures, to serve as a hedge against their underlying assets. Besides these, diversification is another common hedging technique. While hedges can reduce the negative consequences of price fluctuations and mitigate risk exposure, they still come with their own costs and risks. Although long-term investors might not be interested in making a hedge, it is advisable for all kinds of investors to get familiar with this type of risk management and consider both its pros and cons.