All that you need to know about Hedging
Hedging – the word might sound like a practice implemented in gardening; but in investment it takes a whole new meaning. It is about taking position to protect your portfolio against adverse price movements.
Think of it as buying a life insurance policy. It protects and supports your family in case you die. That said it can’t prevent you from dying. But it sure reduces the financial impact of the event. Although the basic purpose is similar, hedging is slightly more complicated than insuring your life. It is the technique of using your investment instruments strategically to offset any risks arising out of adverse price movements. You hedge one investment by investing in another.
Hedging involves investing in two securities that have negative correlations. Also known as pairs trade, hedging helps investors take control of the situation when the industry is volatile.
As a technique hedging is generally used while dealing with options and futures. Let us say you have purchased shares of ABC Company. You believe this is a good company and that you can make some good profits if you keep your investments for long.
Now let’s say there are some short-term losses in the industry that might affect the stock prices of ABC Company negatively. Your main objective would be to protect yourself against the risk of the falling prices of the ABC shares. Your best bet in such a scenario would be to buy a put option on the ABC Company.
A put option will give you a right to sell your ABC stock at a specific price known as the strike price. In case the stock price goes below the strike price, you still get to offset your losses through the money that you gain in your put option.
Hedging may not always help you in making money. But there are a few scenarios where it can actually help you reduce your losses. Here are a few scenarios where you can use hedging:
When the Portfolio is Too Bullish: In this scenario there are high chances to make maximum amount of money since the market is moving upwards. However, that also increases your risks. You can counterbalance this by adding some bearish positions to your portfolio. You can put calendar spreads, put diagonal spreads, or call credit spreads, depending on the situation. If you want to profit from the market rise in volatility you can put calendar spreads or put diagonal spreads. Nevertheless, in cases that necessitate some bearish strategies due to highly volatile market conditions, you may benefit by selling call credit spreads.
When the Portfolio is Too Bearish:You may want to gain some bullish exposure when the portfolio is too bearish. So you can either short put credit spreads or trade naked short puts below the market. If the market is experiencing low volatility you may want to use long call debit spreads to get some bullish exposure.
When the Portfolio is too lopsided:There are portfolios that have good exposure in the extremes. In such cases you may not be able to profit in a ranging market. This is when you may want to use some straddles and strangles to get more neutral. Calendar spreads should help you make money when the volatility is low. This will not only help in raising the middle curve of the portfolio, it will also help you make money from a ranging market.
When your stock is long: You may use a cost-less collar to hedge in such a scenario. This way you can protect your portfolio if there is a slight drop in the stock price in a zero-cost way. You first buy at the money put spread and then sell a call that will finance that trade for a net credit. While the credit that you receive reduces the risk in your trade, it won’t cost you any money.
When the traded options are light or nil:This is a scenario where you don’t have any optionable stocks or you have certain liquid options that you may want to trade. In such a case you may have to look out for a relatable stock or another company security of the same sector. For instance, if you are trading Facebook, you can use Twitter to hedge your position.
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