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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 any risky situation that may lead it to lose its value. However, hedging doesn’t mean that the finances won’t lose value at all but in the event that happens, the asset will not completely lose its value but part of it will remain.

 

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 for this is getting car insurance so that in the event of a car accident and the car suffers damages, the insurance policy will cover it by shouldering the repair costs or even replacing the car with a new unit.

 

How do hedging strategies work?

Looking at the illustration above, hedging is the balance that supports any type of investment, whose most common form is a derivative or a contract whose value is measured by an underlying asset. Say, for instance, an investor buys stocks from a company hoping that in the next couple of years, the price for such stocks will rise. However, on the contrary, the price plummets and leaves the investor to absorb the losses.

Such incidents can actually be avoided 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, if within the specified timeframe the stock prices go down, the investor can invoke the option and sell his stocks at the pre-determined price and still make money out of the investment. It is considered one of the most effective hedging strategies.

 

Examples of hedging strategies

There are various hedging strategies, and each one is unique, which is why 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 can remain afloat.

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

 

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, but even smaller entrepreneurs and businessmen can do it.

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 who thinks this is 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’s already plummeted. At first look, it doesn’t make any sense but after giving it a closer look, it is actually an effective means of offsetting losses.

To understand it better, let’s take as an example a t-shirt retailer who previously purchased 100 shirts for $5 each for a total of $500. Unfortunately, the selling price of the shirts is now down to $3 each, so the retailer decides to buy 50 shirts more for a total of $150. Now, to get the average selling price for these shirts is to add $500 and $150 which totals to $650 and then dividing that by 150 shirts. The result will be $4.30 or just $4 per shirt which is halfway between the original and the current selling price and is still a winning situation.

 

4. Staying in cash

This strategy is as simple as it sounds. The investor keeps his money and does not invest it in any asset in the meantime.

 

Areas of hedging

Hedging can be imposed on various areas such as commodities, which include everything that people use every day like 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 it a tradable property that changes prices easily. Currencies can also be hedged, including foreign currencies, 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

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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