In finance, hedging refers to the way in which risk is minimized by countering loss with corresponding investments. Investors have strategically used strategies to offset the risk of adverse price movements on assets since the beginning of time and new hedging strategies are introduced every day. Let’s look at a few of the most efficient hedging strategies you can use today.
Modern Portfolio Theory (MPT)
This is perhaps one of the most proven strategies in the investment world today due to its effectiveness. Basically, it aims at diversifying your stocks in a way that reduces your risk margin.
As an investor, it is fatal to place all your "eggs" in one basket. Picture an investor, a farmer, for example, holding two stocks. One yields its highest when it rains and the other when it doesn't. Evidently, whether it rains or not, the farmer will still have gains at the end of the season. Therefore, for any investor, it is advisable to diversify the stock in order to reduce the risks produced by one stock.
Options and Futures
Another way to explain hedging is insurance. By hedging their bets, stock traders protect themselves from negative movements by buying or selling commodities before or after they have reached a certain price. Investors will usually hedge these investments through futures and options, as this guide to hedging strategies from JCRA shows.
Options and futures refer to contracts made under strict terms restricting the investor to buy or sell an asset within a specified timeline and at a decided price. There are two positions on options. Firstly, the call option. Here, the buyer has the right to buy an asset once a specified price is reached. With the put option, the owner has the option to sell the underlying asset once it goes below a certain point.
Futures, on the other hand, work a little differently. They allow you to buy commodities at a certain set price at some time in the future. For instance, if you are following corn prices and believe that the price will be higher in the future, then you can buy a futures contract for the price of corn. This will allow you to pay that price once the hike kicks in. This allows buyers to control the price of commodities and resell the same commodities at a higher price later.
Much like options, delta-hedging helps to reduce the risk associated with price fluctuation. This is done by offsetting long and short positions. A good example of this tactic would be delta hedging a long call position by shorting the underlying stock.
Volatility Index Monitoring
Volatility in the market is definitely every investor's nightmare. But, looking on the bright side, monitoring volatility will provide vital information needed for your decision making. Basing your arguments on statistical conclusions, you can predict the next move in the market and make suitable decisions on the way forward. There are many helpful tools out there for monitoring volatility, like VIX.
The investor's world is much like being a guppy in a pool of sharks, and staying alive is paramount. Defence Rotation is a strategy that combines both strategic diversification and market monitoring to define paths to best asset allocation areas. As you diversify on your stock, you will be making decisions based on market fluctuations on the fly. Statistical data goes a long way in this area.
As discussed, hedging involves finding suitable ways of reducing your risk margin as far as possible. Investors hedge one investment by making another. Something to remember though is that the investments should be at negative correlations to produce the desired results.