Beginner's Guide to Hedging: What is Hedging in Stocks?

Guide to Hedging in Stocks

Investing in the stock market can be quite risky without the right strategy and money management system. And that is because a single negative event can overturn a winning position, resulting in a considerable loss.

But with hedging, you’ll never have to worry about huge losses, even when the market goes against you.

Don’t get me wrong; hedging doesn’t prevent bad things from occurring. But if a negative event occurs, your investment will be adequately protected, and the effects of the occurrence will be well mitigated. So if you want to know what is hedging in stocks, please read on.

What is Hedging?

Hedging is a unique risk management strategy involving traders selling or purchasing investments to help lower the risk of their current losing position.

It’s not one of the most common strategies among individual traders. And in most cases, when used, it’s usually initiated after the investor has made their initial investment. Most investors won’t hedge their trades when shorting or buying stocks.

When hedging, a trader would hold an investment moving in the opposite direction of their primary position. So if their initial position starts losing, the hedge will limit or offset the loss. Unfortunately, it does result in a reduction in the potential profits. But if it can help you mitigate your losses, then it is worth it.

What Are Some Reasons for Hedging?

Basically, hedging is like an insurance policy against a certain losing trade. Its main aim is to protect your investment against a negative outcome. Therefore, an investor can hedge their position if they’re not sure of the possible outcome of the trade.

Hedging can help you lock in the profits that you had gained before your trade started dropping.

Another reason why investors hedge their positions is to reduce the likelihood of losing their capital. If your position starts losing, you can hedge it using options and help mitigate a possible huge loss.

Hedging can protect you from making a huge loss to a certain extent in case of a negative outcome.

Last but not least, hedging can also help increase your liquidity level. After all, it will make it possible for you to invest in a wide range of assets on top of your current investment. And if everything goes well, you may end up with more profit.

What Is Hedging in Stock Market?

We already know the general meaning of hedge, but do you know what does hedge mean in stocks? Well, Hedging refers to the act of buying an asset, with your main goal being to eliminate or lower the risk of uncertainty.

The main goal of hedging is limiting any loss that can be caused by an unseen variation in your investment’s price.

In stocks, hedging takes several forms, using derivatives as one of the most common. These derivatives derive value from underlying assets like indices, commodities, or stocks. Stock investors hedge their positions in the following occurrences:

  • Interest rate: the interest rate includes borrowing and lending rates. A change in interest rate is one of the key hazards affecting stock traders.
  • Currencies: foreign currency can also hugely affect the stock market. Some of the dangers associated with currency include volatility risk and currency risk.
  • Securities: securities investment includes indexes, equities, and stocks. These hazards are known as securities or equity risks.

Types of Hedges

After learning what is hedging in stocks, your next step should be finding out how investors hedge their investments. Basically, there are several types of hedging that investors use to mitigate a loss.

Here’s to name a few:

Forwards

Generally, forwards are contracts to sell or purchase certain assets between some independent parties at a certain agreed date and price. It covers contracts of several assets like commodities and forward exchange contracts for currencies.

Futures

On the other hand, futures refer to a standardized contract to sell or purchase underlying assets between independent parties at a certain date, standardized quantity, and price.

Futures may not be the best way to deal with stocks, but they work perfectly with currencies and commodities.

Fortunately, they come with a fixed trading cost, and the futures market is very liquid.

Other common types of hedge:

  • Money market
  • Short straddles on indexes and equities
  • Sporting events

Advantage of Hedging

  • Options and futures are great short-term risk-mitigating strategies for long-term investors and traders.
  • Hedging lets investors survive the hard times in the market and live to make a profit in the future.
  • Most hedging tools can help you lock some profits in most trades.
  • Options allow you to practice complex strategies that can help you maximize profits.

Disadvantages of Hedging

  • It involves a cost that’ll eat into your profit
  • Hedging is a complicated strategy for short-term traders to follow
  • It offers little to no benefits in a market that’s moving sideways
  • Trading things like futures and options require more capital

What Are Some Hedging Techniques?

Investors who know the answer to the question “what does it mean to hedge a stock?” know that there are several hedging techniques. Here are some of the most popular techniques:

Consider a Collar

This technique includes buying and selling options. The main aim of a collar is getting a premium that can help you offset the price of purchasing the stocks. Unlike the other hedge methods, the price of the collars is limited to the strike price.

If the target price is attained before the expiration date, you will not lose your premium, but you may pay capital gain tax.

Sell Covered Calls

Another reliable hedging technique is selling a covered call whose price is above the current market price. Covered calls can provide extra income to your holdings, which can cover your losses if the price plummets. Unfortunately, the calls limit your profit; you must sell when the stock reaches your target price.

What Is a Good Example of Hedging?

To help you understand what is hedging in share market, here is a great example of hedging using options.

If you purchase 1,000 shares at $50 per share in January and its price drops to $40 after a few months, you stand to make a loss.

The negative event has forced some traders to close their position and look for new opportunities. But if you still believe the price will improve. You can hedge that position by purchasing options on a share-by-share basis.

This won’t give you an obligation to sell the stocks at a specific price or within a set period. But if your hedge strikes $35, it will protect you against losses below $35.

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