What does hedging mean?

deltafx writer 22 January 2022

 To reduce the likelihood of losses in a position, investors use hedging, which is a sophisticated form of risk management. Investors rarely use hedging as a trading technique, and when they do, it usually happens after the initial investment. In other words, you wouldn’t hedge your position before buying or selling a stock. By hedging, investors protect themselves against the financial consequences of an unfavorable occurrence. It does not stop all negative situations from occurring. However, if an unfavorable event occurs and you are properly hedged, the damage can be much more insignificant. You may ask yourself, why should I learn it if it is not popular among investors? It is true, many investors ignore short-term fluctuations, and they look for a long-term profit. But to be a professional investor, you need to learn as much as possible about the investment methods of big companies and mutual funds to analyze their activities.

How does hedging work?

The investors who hedge mostly use derivatives. Derivatives are financial contracts backed by a real asset, like a stock. The most frequent derivative is an option. It allows you to purchase or sell a stock at a set price within a time frame.  If you want to know how it keeps your capital safe when you’re exposed to a risky situation, assume you bought a stock. You expected the price to rise, but you wanted to be safe if it dropped. Using a put option, you can reduce that risk. You pay a small fee to the broker and instead receive the right to sell the stock at the same price that you had bought them. If the stock price drops, you’ll be able to trigger your put option and sell them for the initial buying price. In the end, you only paid some fees and didn’t lose a lot of money. It is like insuring your trades. However, this is just one strategy of hedging, and there are other ways to do so.

Diversification is another important strategy, and investors can use it when they have different assets in their portfolios. Obviously, not all assets rise and fall together. If the price of one falls down, you do not experience a big loss. Having different assets helps you compensate for the losses related to an asset. Suppose you have five different assets in your portfolio. The general value of each type of asset is $100. Now, if the price of one drops to $50 and the other assets’ prices grow a few dollars, they manage to compensate for this loss to some extent. That is why having a mixed portfolio has always been among the top recommendations to novice investors.

What is a hedge fund?

Hedge funds started their activities in global financial markets in 1950. In the beginning, they aimed to cover the risk of investment in bearish markets. After a while, these funds managed to attract a great deal of capital. Today, they are very popular, and many investors use them.

Financial institutions’ Hedge funds are investment institutions that attract wealthy customers who own high amounts of capital. The managers of such funds invest the collected money in different instruments and receive a commission instead. These managers are professionals who use many complicated methods and analyses to make considerable profits. Therefore, the returns of investment in hedge funds are high. The managers of these funds aim to minimize the investment risks and maximize the profits for the investors.

Hedging pros and cons

Using derivatives such as futures trades allows investors and traders to manage risk.

It is a good strategy to make a logical profit.

Hedging minimizes the effect of fluctuations on traders’ portfolios.

It provides traders with a new vision about the price actions.

You can use it for many assets.

Hedging limits the potential profit.

You should always monitor the market if you want to use this strategy.

It is not suitable for short-term trades.

Fees may sometimes be high.

Hedging requires a high level of trading knowledge, and it is not very easy for many traders.

Conclusion

A successful investor must be aware of different trading methods, especially every risk management strategy. Although, he may not use them frequently. Knowledge is a great weapon in financial markets. If you don’t use your full potential, someone else will do so, and he will be the one who makes the profits. Hedging is a good strategy for managing trading risks, but usually, professional traders use it. It may seem a little complicated at first, but you can learn it perfectly with practice. DeltaFX has provided you with a risk-free environment to practice any strategy, and it is called the demo account. Use it to gain the necessary experience for trading in real accounts.

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