What is Hedging: Types, Advantages and Disadvantages

Hedging is a technique that supports investments that protect your profit while limiting the losses of one asset by purchasing or selling another asset. 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. In this article on what is hedging, we will be discussing the types, advantages and disadvantages of hedging.

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. 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.

Table of Contents

• What are Hedge Funds?
• Working of Hedging
• Types of Hedging
• Strategies in Hedging
• Advantages
• Risks

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What are Hedge Funds?

• A hedge fund is a type of investment fund that pools in money from wealthy investors and tries to make high returns by using advanced and sometimes risky investment strategies.
• Unlike traditional mutual funds, hedge funds have much more flexibility in how they invest money. They can use complex techniques like short selling, borrowing money (leverage), and trading complex financial instruments.
• The people who manage hedge funds, called hedge fund managers, are often very skilled and try to make money in both rising and falling markets. They get paid a management fee and a performance fee.
• Hedge funds can invest in stocks, bonds, real estate, derivatives, commodities, and even newer assets such as cryptocurrencies. Their goal is to generate returns that are better than traditional investment methods.
• These funds use advanced strategies like arbitrage (finding price differences in markets), hedging (protecting against potential losses), and algorithmic trading.

How does hedging work?m

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 prices 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.

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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: A 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 the 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.
• Financial Hedging: It uses financial instruments to offset potential losses. In financial hedging, common tools include forwards, futures, options, and swaps.
• Natural Hedging: In natural hedging, risk is reduced through business structure or diversification. This type of hedging involves matching assets/liabilities or spreading investments across sectors.
• Operational Hedging: This type of hedging mitigates risk by adjusting business operations. In operational hedging, examples include flexible manufacturing or maintaining multiple suppliers.
• Cross-Hedging: In cross-hedging, a correlated asset is used when an exact match isn't available. This type of hedging relies on price relationships between similar assets or markets.
• Static vs. Dynamic Hedging: In static hedging, a fixed position is maintained, while dynamic hedging adjusts continuously. This type of hedging choice depends on market volatility and objectives.
• Perfect vs. Imperfect Hedging: This type of hedging distinguishes between eliminating all risk (perfect) and reducing most risk (imperfect). In practice, most hedges are imperfect due to market complexities.
• Commodity Hedging: In commodity hedging, protection against price fluctuations in physical goods is provided. This type of hedging is commonly used by producers and consumers of raw materials.
• Currency Hedging: This hedging manages risk from foreign exchange rate fluctuations. In currency hedging, strategies are essential for businesses with international operations or investments.
• Interest Rate Hedging: In interest rate hedging, protection against adverse movements in interest rates is provided. This type of hedging is crucial for entities with significant borrowing or lending exposure.
• Portfolio Hedging: This type of hedging aims to reduce risk across an entire investment portfolio. In portfolio hedging, broad market instruments like index futures are often employed.

Hedging Strategies

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

1. Tracker hedging

• A tracker hedging is a risk management strategy used to minimize potential losses by creating a portfolio that tracks or mirrors the performance of a benchmark index.
• The primary goal of this type of hedging is to replicate the returns of a particular market index with minimal deviation.
• It is mostly used in exchange-traded funds (ETFs) and index-based investment strategies.
• Tracker hedging aims to match the performance of a specific market index (like S&P 500, NASDAQ, FTSE 100)

2. Data hedging

• This type of hedging strategy is risk management strategy specifically designed to protect digital assets, information, and data infrastructure.
• It involves creating multiple layers of protection and backup mechanisms to mitigate potential data loss, breaches, or system failures.
• Unlike traditional cybersecurity, it creates strategic redundancies and protection strategies.
• It mitigates the financial risk of an option through hedging against price changes in the underlying.

3. Long/Short Equity Strategy (In-Depth)

• This strategy of hedging is about creating a balanced investment approach that can generate returns in different market conditions.
• For example, a hedge fund might identify a technology company they believe is overvalued (like Company A) and short its stock, while simultaneously buying shares of a strong competitor (Company B) they believe will outperform.
• The goal is to reduce market risk. If the overall tech sector declines, the short position in Company A can offset potential losses in the long position of Company B.
• Managers use extensive research, financial analysis, and predictive models to select which stocks to go long or short.

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 favourable 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.

While no hedging strategy can completely eliminate risk, these approaches provide investors, corporations, and institutions a way to earn profits in the dynamic financial markets. It is therefore important to learn about hedging and then practice it with caution. Expert guidance can also help in mitigating risks.