What is Hedging? | Strategies for Mitigating Risk

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Compound Real Estate Bonds


December 3, 2022

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Are you looking for ways to mitigate financial risks in case of market fluctuations, changes in interest rates, volatility, and dislocations? Well, there is always a solution to any problem. Likewise, you can use hedging strategies to lower the risk factor in financial investments. This post teaches you everything about hedging, how it works, its benefits, risks, disadvantages, and more, with practical examples and strategies. Let's dig deeper: 

What is Hedging?

Hedging is a financial strategy that limits the risks in investments. It is similar to taking home insurance. Suppose you have secured your home by taking insurance for floods. So, even if there is no flood, you must pay the monthly down payment. 

You won't prevent the emergency with insurance but secure your home or investment. Similarly, with hedging, you will recover the damage but won't safeguard your assets. However, you may lose the potential gains if there is no market fluctuation as you predicted. 

You might wonder how you can lose the gains by investing more. The answer is - to hedge, you have to invest in opposite assets. It means the assets should be correlated. If your investment loses value due to market trends, your hedging investment should recover it. So, if your predictions are wrong, you may lose in the hedging investment, and it may turn fruitless, and you will have to invest money anyways, similar to the home insurance example.

How Does Hedging Work?

Hedging is a strategic investment that will move in the opposite direction of your previous or core investment in case of market fluctuation. So, if your core investment declines in value, the hedge investment may cover the loss, limiting the risks of losing all your investment. 

You can use derivatives as hedges against the underlying assets. Derivatives are financial contracts or policies that state the relation between two different assets. These are documents with information about your investment alternatives, options, futures of those bonds, and more. These underlying assets are investments like bonds, stocks, currencies, interest rates, or indexes. You can compare these assets and use them in hedging. 

You can also use the option put as a hedge. That's another financial contract that gives you the alternative to sell the shares or assets but doesn't give you the obligation to sell them at a specific time. Simply put, you can sell the shares or stocks but can't influence the market. 

Portfolio diversification is another way of hedging. Strategically dividing your wealth into different investments after closely monitoring the market can also be considered hedging. However, it requires capital, calculation of risk, and precise decisions. 

Note: A perfect hedge is an investment myth. It can only be possible on paper and not in the actual market. You can't predict if your hedge investment will increase the exact amount of your core investment losses. Your core investment and hedge may not move in the opposite direction, and that's still a significant risk.

Different Hedging Strategies 

1. Asset Allocation 

You can diversify your portfolio and buy assets in different areas. You can spread your capital in cash, bonds, stocks, bitcoins, real estate, and other forms. So, if there is fluctuation in the stock market, your real estate investment will save you from the loss. However, finding the opposite directional assets is tough. 

2. Trading in Safe Haven Assets

You can invest in safe-haven assets like government bonds, gold, wine, and currency pairs. Government bonds offer fixed returns over a period. You can choose accounts that give compound interest and secure your money. Gold can also be your fixed investment that grows over time similar to vines. The older the vine, the more value it holds because getting an old vine is rare and always in demand. These are the safest options, and you don't have to worry about market fluctuations. 

3. Pairs Trading 

As the name suggests, this strategy involves pairing two or more assets with long and short positions. You must identify the correlation between the two assets and pair them to get benefits. 

Note: Due to its complexity, pair trading is not for beginner investors. 

4. Hedge Funds 

Hedge funds give average returns and employ sophisticated strategies. You have to offer compensation to the portfolio manager if these funds make a profit. These are high-risk funds, but you can use them during the market inflation period.

5. Staying in Cash 

You can choose to stay in cash in times of market crises. That way, you won't be affected by the investment losses, but at the same time, you won't get any profit. That can be your last strategy when trying to protect what you have. 

Apart from these, you can invest in arbitrage, derivatives, delta, and average down investments for hedging. 

Advantages of Hedging 

  • Hedging makes it easy for investors to face challenging market periods. 
  • It minimizes short-term risks for long-term investors.
  • Hedging strategies can lock the profit. 
  • With successful hedging, you can secure your investments and protect yourself from fluctuating interest rates, currency exchange rates, and commodity prices. 
  • As these are short-term investments, hedges don't need you to invest time. 
  • Hedging can give you alternatives and options to secure yourself from volatility. 

Risk of Hedging Strategies 

  • The expense of hedging might significantly reduce the profit.
  • Since costs and benefits are frequently inversely correlated, lowering risk also implies lowering profits.
  • Hedging is a challenging strategy to implement for the majority of short-term traders, such as day traders.
  • Hedging has little value when the market is doing well or heading in the wrong direction.
  • Higher account requirements, such as additional capital or balance, are frequently demanded when trading options or futures.
  • Hedging is a sophisticated trading method, and it demands competent trading knowledge and expertise to be effective.

The Bottom Line 

Now you know how hedging works, you can use these strategies and reduce the risk factor. However, you must keep an eye on the market, other investors, companies, and trends to alter your strategy. Joining a community always helps in such situations. So, join Compound Banc and keep learning about different investment techniques and hacks. Stay tuned!

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