What is Hedging: Types, Advantages and Disadvantages

What is Hedging: Types, Advantages and Disadvantages

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Jaya
Jaya Sharma
Assistant Manager - Content
Updated on Mar 4, 2024 18:44 IST

Hedging is a technique that supports investments that protects your profit while limiting losses of one asset by purchasing or selling another asset.

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In this article on what is hedging, we will be discussing the types, advantages and disadvantages of hedging.

Table of Contents

What is Hedging?

Hedging refers to a risk management strategy that is meant to protect future prices or to limit losses. It involves buying and selling investments to reduce the risk of losing an existing position. Hedging is not a very commonly used trading strategy but it is used after an initial investment is made. The objective of hedging is mitigating potential loss for an existing position.    

A hedge consists of taking an opposite position in a related or derivative security based on the asset that will be hedged. One of the effective hedging instruments is derivative. These securities move in correspondence to one or more underlying assets. Futures, options, swaps and forward contracts are examples of derivatives that help in setting up a trading strategy. Here, a loss for an investment is mitigated by the gain in a comparable derivative.

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How does hedging work?

Heding is a practice that helps in reducing and controlling exposure to risks. For effectively using hedging, it is important to make another investment in a targeted and controlled manner. It uses financial instruments as well as market strategies for offsetting the risk related to adverse movements in price. By making a trade in another investment, investors hedge one investment. 

Let us consider an example where you have bought a stock a $100 per share. Now, you are concerned that stock price will decrease massively. One of the methods to limit the potential loss is by purchasing a put option on the stock with the strike price of your choice. Once the price of the stock falls below the set price, you will be able to sell the stock.

Types of Hedging

The following are some of the popular types of hedging:

  • Forward exchange contract: This type of contract occurs between the bank and its customers where the conversion of currencies take place at a future date at an exchange rate in advance under the contract. Through a forward contract, an exchange rate is fixed in advance to avoid exchange rate risk. 
  • Commodity future contracts: Commodity future contract refers to an agreement for buying and selling a predetermined amount of commodity at a fixed price on a specific future date. These are used for hedging or protecting investment positions. They are also used for betting on the directional move of the underlying asset. 
  • Currency future contracts: They are exchange-traded futures contracts that mention price in one currency at which another is bought and sold at future date. These are legally binding and counterparties that hold contracts. It is mandatory to deliver the currency amount at a specified price on a set delivery date. 
  • Covered Calls: It is a two-part startegy where stock is owned or purchased. Calls are sold on the share-for-share basis. When a covered call is sold, its premium can be received and kept as income. It also helps investors in targeting a selling price for stock above the current price.
  • Short Straddles: It is an option strategy that is composed of selling both call and put option with same strike price and expiration date. It is used when traders have a belief that the underlying asset will not move higher or lower significantly over lives of options contracts.

Hedging Strategies

These are the general risk management policies of financial and physical trading firm that help in mitigating the risk. The following are the strategies:

  • Tracker hedging: It is a pre-purchase approach where open position is decreased when it reaches the maturity date. 
  • Back to back: It is a strategy where any open position gets immediately closed. This technique is applied in the commodity market. It is applied when a customer’s price is calculable from visible forward price at point of customer sign-up.
  • Risk reversal: It is a strategy where call options are bought and put options are sold simultaneously. 
  • Data hedging: It mitigates the financial risk of an option through hedging against price changes in the underlying.

Advantages of Hedging

The following are the advantages of hedging:

  • Through hedging, there is a reduction in the impact of probable losses such as currency and price fluctuations, market changes, and other changes. Overall, financial stability is maintained within the system.
  • It provides greater flexibility related to your investment strategy. This allows taking more risks since, through hedging, potential losses are mitigated. 
  • Through hedging, investors can get a greater degree of predictability in financial outcomes. 
  • By gaining the ability to manage risk helps in increasing your confidence in your investment decisions.
  • Companies use derivatives to eliminate the uncertainty of future commodity prices. Using forward and future contracts, the prices of key goods are locked in advance of the delivery date.

Associated Risks

The following are the risks associated with hedging:

  • It is a technique that is used for reducing risk. However, it is not a perfect strategy and does not guarantee that the loss will be mitigated. 
  • While hedging reduces your potential losses, it also limits your potential profits even when the market is moving in a favorable direction.
  • These strategies are complex and require an understanding of the market. In case you fail to understand the strategy, it would be difficult to implement these strategies accurately, which could cause you losses. 
  • For hedging, investors require resources such as capital and time. These resources could be utilized for other investments with higher returns. However, through hedging, investors might miss out on investment opportunities with higher returns.
About the Author
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Jaya Sharma
Assistant Manager - Content

Jaya is a writer with an experience of over 5 years in content creation and marketing. Her writing style is versatile since she likes to write as per the requirement of the domain. She has worked on Technology, Fina... Read Full Bio