The term ‘hedging’ may sound like something that’s done to your garden, but in the investment industry, it is considered a move every investor, new and experienced, should know. In the world of the stock market, hedging is a process of getting portfolio protection.
In this post, we will talk about hedging, derivatives, and how you, as an investor, can lower risks in the financial market.
Introduction: What is hedging?
To put it simply, hedging can be considered as a form of insurance that helps you insure your position in the event of a negative impact on finances. Of course, this doesn’t prevent all negative events from happening, in case something negative happens, the impact is reduced.
In life, we use hedging almost everywhere! So, buying a homeowner’s insurance hedges you against break-ins, fires, and other unforeseen disasters. Much the same way, investors, portfolio managers, and corporations, use hedging to reduce their exposure to risks.
Hedging involves strategically using market strategies and financial instruments to offset the risk of adverse price movement.
Basics of derivatives
We’ve already mentioned that certain financial instruments are used as hedging techniques. These financial instruments are known as derivatives.
You can use derivatives as efficient hedges against the assets they’re linked to because the connection between them is usually well-defined. Derivatives are financial instruments that mirror the movements of one or more underlying assets, such as option trading, swaps, futures, and forward contracts. These underlying assets can encompass a wide range of things like stocks, bonds, commodities, currencies, indexes, or interest rates. With derivatives, you have the potential to create a trading strategy where a loss in one investment can be lessened or even canceled out by a gain in a related derivative.
4 types of derivatives – In detail
The four main types of derivative are futures, options, forwards, and swaps.
- Futures: Futures are standardized contracts that enable the holder to buy or sell an asset at an agreed-upon price on a specified date. These contracts are actively traded on stock exchanges, and their values are marked to market daily, meaning contract values are adjusted in response to market movements until the expiration date.
- Options: Option trading grants the buyer the right to purchase or sell an underlying asset at a specified price within a defined time frame. Importantly, the buyer is not compelled to exercise this option. The entity selling the option is referred to as the option writer, and the specified price is termed the strike price.
- Forwards: Forwards require the holder to meet contractual obligations, but they lack standardization and are not traded on stock exchanges. Instead, forwards are available over the counter and can be tailored to suit the specific needs of the contracting parties.
- Swaps: Swaps are derivative contracts where two parties exchange their financial commitments. These exchanges are based on a notional principal amount agreed upon by both parties, and no actual principal is exchanged. The cash flows in swaps are determined by an interest rate, typically featuring one fixed cash flow and another that fluctuates based on a benchmark interest rate.
Reducing financial risk by using the right hedging instruments
While there are a few effective hedging strategies often used by investors to reduce market risk, three popular ones out of those include modern portfolio theory, options, and volatility indicators. So, let’s deep dive into these and find out how they can be of help to you.
Modern Portfolio Theory
One of the main tools at the disposal of investors is the modern portfolio theory (MPT), which utilizes diversification to group assets and reduce volatility. With MPT, you’ll be able to employ statistical measures to determine an efficient frontier, finding the expected return for a defined level of risk. This theory delves into the correlation between your assets and their volatility to craft the optimal portfolio.
When you dive into risk management, you will find that many financial institutions have incorporated MPT into their practices. The efficient frontier forms a curved linear relationship between risk and return, helping in varying risk tolerances. You can use MPT to help you select a portfolio tailored to your specific risk preferences.
If you’re looking to safeguard an individual stock with decent liquidity, you can often purchase put options as insurance against potential downward movements. Puts increase in value when the underlying stock’s price drops and thus, are often considered one of the prime types of derivative.
However, for those investors with a broader, diversified stock portfolio, index options can be a better choice. Index options track major stock market indexes like the S&P 500 and Nasdaq, providing a snapshot of the overall economy since these indexes cover multiple sectors. Stocks tend to move together, particularly during periods of high volatility.
To minimize your risk, you can hedge with put options on these indexes. One strategy to consider is bear put spreads, which can help reduce your risk exposure. While this protection still involves costs, index put options safeguard a more extensive range of sectors and companies, which can be beneficial for you.
Volatility Index Indicator
You can also employ the volatility index (VIX) indicator as a hedge. The VIX assesses the implied volatility of at-the-money ‘calls and puts’ on the S&P 500 index. It’s often referred to as the fear gauge because it climbs during periods of heightened market volatility. Typically, when it’s below 20, it suggests low volatility, while a reading of 30 or higher indicates significant volatility. You’ll find exchange-traded funds (ETFs) that mirror the VIX. You can use ETF shares or options to take a long position on the VIX, effectively using it as a hedge against volatility.
Hedging is a vital financial strategy that lets you reduce different types of risks you might encounter as an investor or trader. Think of a hedge as a counteracting or opposite move you make that profits when your primary position faces losses or the other way around.
As mentioned earlier, a hedge works like purchasing an insurance policy for your investments or portfolio. You can create these balancing positions by using closely related assets or by diversifying your holdings. However, the most prevalent and effective way to hedge is often by employing derivatives like futures, forwards, or options contracts.
To sum it all up –
Risk is a fundamental but sometimes tricky aspect of investing. No matter what type of investor you want to become, having a fundamental grasp of hedging strategies will enhance your understanding of how investors and companies safeguard themselves.
Even if you don’t plan to delve deeply into the intricate world of derivatives, familiarizing yourself with the principles of hedging will boost your comprehension of the market. This knowledge will always contribute to your growth as an investor.