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What is hedging? Protecting assets from market storms

Hedging in the financial markets is one of the risk management techniques. It’s a sort of insurance cover to protect against potential losses from an investment.

Hedging is suitable for both private investors and investment funds. Some of them are hedge funds, managing portfolios worth $5 million or more. As of 2022, Bridgewater founded by Ray Dalio is considered the largest hedge fund with about $150 billion under management.

Portfolio managers use cunning strategies and hedge assets via derivatives. Private investors have to rely on themselves. Often portfolio protection is reduced to opening short positions. And for long-term and passive investors, hedging may not be suitable as it is rather complicated and involves excessive intervention in the portfolio.

What is hedging

Hedging allows investors to protect their capital from drawdowns and offset potential losses in an unfavorable scenario.

Let’s say you own shares in a company and plan to keep them, but you’re afraid of a market crash. In this case, you can “buy insurance”, betting that assets will soon fall. You open an opposite position, potentially bringing profit amidst a falling market to do that.

If the scenario is not implemented, you lose your “stake” — a small portion of the capital allocated to the hedging position. But, if the market does go down, the hedge compensates for the drawdown in stocks.

Hedging strategies

There are different types of portfolio hedging.

Direct hedging

The most common hedging method is when an investor has a position in his portfolio and he takes another position in this asset, but in the opposite direction. The opposite position is usually smaller. It’s executed using a short sale or an inverse ETF, for example. It is basically trading the same asset in different directions at the same time.

As a result, in a falling market, you partially compensate for losses and protect against volatility. And if you open an equal hedging position, you can fix the cost of the investor’s capital. Of course, one should also keep in mind the associated costs and commissions.

Cross-hedging is when the asset in the portfolio and the underlying asset of the hedge is not the same. For example, you are hedging blue chips with a futures contract on the S&P 500 index.

Composite hedging

One can also use several hedging instruments at once. These instruments help reduce risks due to diversification. For example, to protect a portfolio with US stocks, futures for the S&P 500 index and some dollar currency pairs are used simultaneously.

One can calculate the optimal ratio of hedging instruments using formulas based on volatility and correlation of assets.

Cross-industry hedging

Protecting a portfolio with assets from different industries could make a nice balance.

For example, you can use the stocks of companies focused on exports and imports or derivatives. If the dynamics of the exchange rate change, one segment will lose, and the other will win.

Static and dynamic hedge

One can modify the hedging position during the investment process. For example, you expect an asset to fall, but it keeps rising. The probability of a correction is higher, so you increase the amount of hedge at the new price.

How is hedging used in Forex?

Forex is a market where one should understand the specifics of currency pairs and their correlations in the hedging process.

For example, EUR/USD and USD/CHF have a negative correlation and can be used as a hedge against each other.

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Important things to know about hedging

  1. Hedging is used to manage market risks and mitigate the effects of an adverse price change of an asset.
  2. Hedging was originally used in the commodity markets when dealing with raw materials. That contributed to trade and pricing, making the market more stable and predictable.
  3. In most cases, hedging is a tool used by professional portfolio managers who often trade complex derivatives.
  4. Crashes can happen unexpectedly. Research shows that sometimes it’s better to just cut positions and cash out.
  5. Hedging, unlike diversification, allows to fully protect the portfolio from drawdown. But for passive and long-term investors, the best way to reduce risk is by diversifying one’s portfolio. It seems easier. And one doesn’t have to pay for it.