The technique of hedging is also followed at an institutional level by portfolio and fund management companies to minimize their exposure to different types of risk and to decrease its negative impact.
In the stock market, the hedging technique is used in the following areas:
- The interest rate
Hedging is also a technique that will help the investor to gain profits by trading different commodities, currencies or securities. Hedging is of three types namely:
- Forward contract: The forward contract is a non-standardized agreement to buy specified assets at a determined price on a date agreed by two independent parties. The forward contract is drawn for various types of assets like commodities, currencies, etc.
- Futures contract: The futures contract is a standardized agreement to buy specified assets at a specified price on a date agreed by two independent parties. The futures contract is drawn for various types of assets like commodities, currencies, etc.
- Money Markets: Money markets cover many types of financial activities of currencies, money market operations for interest, calls on equities where short-term loans, borrowing, selling and lending happen with a maturity of one year or more.
When looking for investment options, hedging helps the investor to spread their risks and reduce them to a certain extent. As the market is unpredictable so are the hedging techniques. The hedging technique will have a constant modification as per the market situation and the investment type.
Some of the common strategies followed in hedging are as follows.
- Asset allocation: While investing, the investor can hedge their risks by diversifying their portfolio into asset allocations that carry risk and assets that provide stable returns and balance their portfolio.
- Structuring the portfolio: Another type of hedging is the technique of structuring. Here the investor will invest a portion of their portfolio in debt and some in derivatives. Debt gives stability and derivatives to protect the investor portfolio from risk.
- Hedging by options: This technique involves call and puts options of assets. This helps the investor to safeguard their portfolio directly.
Benefits of hedging:
- The basic advantage of hedging is that it limits the losses of the investor.
- Hedging protects the profits of the investor.
- It increases the liquidity of the financial markets as hedging prompts the investor to trade across different markets of commodity, currencies and derivative markets.
- The hedging offers flexible price mechanism as it requires very less margin outlay.
Hedging offers a scalable advantage to investors and traders to effectively trade in the market. As risk is an essential part of the trading cycle and its main motive is to gain profit. However, as the market remains unpredictable, hedging offers a safety net for investors and helps them to protect themselves from market uncertainty.