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Hedging

Protection from financial risks

What is Hedging?

Hedging is a financial strategy that should be understood and used by investors because of the advantages it offers. As an investment, it protects an individual’s finances from being exposed to a risky situation that may lead to loss of value. However, hedging doesn’t necessarily mean that the investments won’t lose value at all. Rather, in the event that happens, the losses will be mitigated by gains in another investment.

 

Hedging

 

Hedging is recognizing the dangers that come with every investment and choosing to be protected from any untoward event that can impact one’s finances. One clear example of this is getting car insurance. In the event of a car accident, the insurance policy will shoulder at least part of the repair costs.

 

How do hedging strategies work?

Hedging is the balance that supports any type of investment. A common form of hedging is a derivative or a contract whose value is measured by an underlying asset. Say, for instance, an investor buys stocks of a company hoping that the price for such stocks will rise. However, on the contrary, the price plummets and leaves the investor with a loss.

Such incidents can be mitigated if the investor uses an option to ensure that the impact of such a negative event will be balanced off. An option is an agreement that lets the investor buy or sell a stock at an agreed price within a specific period of time. In this case, a put option would enable the investor to make a profit from the stock’s decline in price. That profit would offset at least part of his loss from buying the stock. This is considered one of the most effective hedging strategies.

 

Examples of hedging strategies

There are various hedging strategies, and each one is unique. Investors are encouraged to use not just one strategy, but different ones for the best results. Below are some of the most common hedging strategies that investors should consider:

 

1. Diversification

The adage that goes “don’t put all your eggs in one basket” never gets old, and it actually makes sense even in finance. Diversification is when an investor puts his finances into investments that don’t move in a uniform direction. Simply put, it is investing in a variety of assets that are not related to each other so that if one of these declines, the others may rise.

For example, a businessman buys stocks from a hotel, a private hospital, and a chain of malls. If the tourism industry where the hotel operates is impacted by a negative event, the other investments won’t be affected because they are not related.

 

2. Arbitrage

The arbitrage strategy is very simple yet very clever. It involves buying a product and selling it immediately in another market for a higher price; thus, making small but steady profits. The strategy is most commonly used in the stock market.

Let’s take a very simple example of a junior high school student buying a pair of Asics shoes from the outlet store that is near his home for only $45 and selling it to his schoolmate for $70. The schoolmate is happy to find a much cheaper price compared to the department store which sells it for $110.

 

3. Average down

The average down strategy involves buying more units of a particular product even though the cost or selling price of the product has declined. Stock investors often use this strategy of hedging their investments. If the price of a stock they’ve previously purchased declines significantly, they buy more shares at the lower price. Then, if the price rises to point between their two buy prices, the profits from the second buy may offset losses in the first.

 

4. Staying in cash

This strategy is as simple as it sounds. The investor keeps part of his money in cash, hedging against potential losses in his investments.

 

Areas of hedging

Hedging can be used in various areas such as commodities, which include things such as gas, oil, meat products, dairy, sugar, and others.

Another area is securities, which are most commonly found in the form of stocks and bonds. Investors can buy securities without taking possession of anything physical, making them an easily tradable property. Currencies can also be hedged, as well as interest rates and weather.

 

Final thoughts

Hedging is an important protection that investors can use to protect their investments from sudden and unforeseen changes in financial markets.

 

Additional resources

Thank you for reading CFI’s explanation of hedging. CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

  • Buying on Margin
  • Long and Short Positions
  • Stock Option
  • Investing: A Beginner’s Guide

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