Hedging your investments is one of the most important things you will have to learn as an investor if you want to minimise risks and make profits.
What do professional traders know about investments and market volatility that others do not know? Of course, they know how to hedge their investments because many have made significant losses that hedging could have prevented.
Hedging will allow you to protect your investment, improve your long-term returns, and possibly make more money. So, if you are interested in learning this authentic investment strategy, you are in the right place; this is a comprehensive guide on hedging your investments; read till the end to get all the basic information you need.
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What is Hedging?
Hedging is offsetting the risks involved in one investment by making another investment. It uses different financial instruments and strategies to reduce the risks of any adverse price movements in your investment. So, you can hedge one investment or trade by opening another position in the market.
The two positions will have different price movements such that when one price increases, the other decreases. So, if you lose in one of the trades, you will undoubtedly profit from the other.
However, a risk reduction also means a reduction in potential profits. So, hedging can only reduce potential loss and not maximise potential gain. If the first investment makes money, you will have reduced profit, but if the investment loses money, your hedge will successfully still reduce your loss. Therefore, hedging should be done when your investment is at risk.
Think of hedging as a form of insurance on your investment; when investors hedge, they insure their investment against any negative event that may impact their finances. This will not prevent all the adverse events that could affect your investment, but it will significantly reduce its impact on your finances.
Strategies for Hedging Your Investments
There are many types of hedging strategies, and each can be applied in different scenarios, but you must first understand them thoroughly to choose the one best suited for your investment. Here are the most common hedging strategies for all investors.
Derivatives
Hedging with derivatives involves futures, forwards, and options contracts.
Futures
Futures are standardised trading contracts where two traders agree to buy or sell a specific asset at a predetermined price on an agreed future date. This is commonly used to hedge against price fluctuations in currencies, interest rates, and commodities.
Forwards
Forwards are used when price movements are volatile; they are similar to futures. They involve a contract or agreement entered by traders to buy or sell an asset on a future date at a predetermined price. However, forward contracts are not traded on exchanges, and they are not standardised.
Options
Options are contracts that provide the rights to buy or sell an underlying asset at a predetermined price before a specific date, but it is not an obligation. Options are best used to hedge against market price changes in stocks, bonds, and other assets.
Pairs Trading
Pairs trading is arguably the most commonly used hedging strategy; it is a long-short hedging method, so it is market neutral. In this hedging strategy, it doesn’t matter if the two securities belong to the same asset class as long as they have a positive correlation.
Diversification
Diversification is a hedging strategy that allows you to spread risks across various asset classes and investments. This strategy seeks to reduce the risk of concentration of one portfolio. With diversification, you have to invest in different assets from different classes, like stocks, bonds, commodities, and cryptocurrencies, so that if anyone decreases in value, others will rise. You won’t make a massive loss if anything happens to one of the investments compared to when you invest all your money in one asset.
Trading Safe-haven Assets
Safe haven assets include gold and other precious metals, government bonds, and currency pairs such as USD, JPY, and CHF. These assets are considered safe-haven assets in the forex market because either economy is particularly strong with stable rates. So, investing in them means you will have to deal with less volatility.
How to Choose the Best Hedging Strategy for Investment
All hedging strategies have good sides and downsides; there is no sure way to determine which is best when hedging your investment. However, you can check for their advantages and disadvantages to make informed decisions.
There are several factors you will need to consider as well. First, you must decide how much of your portfolio you will hedge. If it is an equity portfolio that is part of a diversified portfolio, then hedging it means you have hedged your entire portfolio to a large extent. So, in this type of portfolio, you can choose a smaller hedge. On the other hand, if the whole portfolio or investment is in equities, you may need to hedge at least 50% of it.
Also considered are the market indices that match the portfolio and the average of its stocks. The higher the beta, the larger the hedge it would need.
So, there are many things to consider to determine the type of hedging strategy that is best suited for your investment. Still, once you know the hedge you want, you should look at the indicative prices to calculate how much the plan will cost. Estimate and compare the costs between different hedging strategies and the level of protection they offer, so you will be sure to choose the best one.
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Hedging your investments will save you from losses and lock in profits, and it is one of the best ways to survive in difficult market periods. It can also help you diversify your portfolio with numerous asset classes and give you protection against changes like interest rate inflation, currency exchange rates, and more. So, it has numerous benefits, and it is worth learning.
However, it would be best if you fully understand the concept of hedging your investments and choosing the right hedging strategy in order to get your desired results.
