Hedging: A Lesson in Risk Management

We know that trading, through profitable, is a risky venture. While it offers huge profits to traders, it also carries the risks of enormous losses in case of a market slowdown.

A market doesn’t work as per our own wishes. Instead, it functions as per a complex mechanism involving a multitude of parties and factors from across the world. An event in one part of the world can enormously impact the market in other parts of the world.

In events such as a natural disaster or a geopolitical crisis, a global market meltdown isn’t an unlikely event, and traders find it impossible to manage the losses.

Keeping such factors in mind, investors have devised intricate risk management strategies to contain overall losses. One of such strategies is hedging, much talked about, but rarely understood.

You must certainly have heard of hedge funds. Often mentioned in tandem with extremely wealthy investors, hedge funds apply a pretty reliable strategy of managing risks associated with an asset with the purchase of another asset.

In this blog, you will learn about hedging and why it is a crucial strategy for investors.

What is Hedging?

Hedging is a strategy in which a trader makes a purchase in order to minimise the price risk of an already purchased asset.

To put it simply, hedging involves executing a trade with the sole purpose of managing the risk of a downward price movement of another asset you already hold.

 

Hedging involves the purchase of derivatives for risk management, with options and futures being the most common types of derivatives.

Hedging Through Options Derivatives

A common way to hedge is to trade an option derivative.

Suppose you buy 1,000 stocks of a chips company named MNO Chips Company, with each stock priced at $10. You bought 1,000 MNO stocks for $10k with a long-term perspective.

But you are concerned that an ongoing agrarian crisis could lead to a rise in the prices of potatoes, thereby leading to a short-term loss for the company.

In such a situation, you can order a put option on MNO for $4 per share. The option gives you the right to sell the stock at a specific price of $8 per share (also called the strike price) in case the stock’s price plummets.

Now, there are two possible scenarios: either the stock’s price will rise, or it will fall.

In case the MNO stock’s price rises to $18 within a period of a year, you decide to sell your stocks and make a profit of $8k.

You will obviously not exercise the put option but end up losing $4k for apparently nothing.

In conclusion, you collected an overall profit of $4k.

But what happens if the MNO stock’s price drastically falls to $3 within a year?

You decide to exercise the put option and sell all the 1,000 MNO shares for $8k, losing $2k. Remember you also spent $4k on the put option. You have lost $6k at the end of the year.

However, consider the scenario if you hadn't purchased the put option. You would be forced to sell all the 1,000 MNO shares for $3k, losing $7k in the process.

• Without a hedge, you made a loss of $7 on MNO shares.

• With a hedge, you made a loss of $6k on the same shares.

Hedging helped you limit your overall loss by $1k, not a small amount.

This might look like a complex exercise and the loss limit rather modest.

However, hedging minimises exposure to risk significantly when the amount is multiplied n times.

Why else do you think hedge funds engage in the practise of hedging?

Hedge funds invest in the market on the behalf of institutional investors and high net worth individuals (HNIs) and engage in hedging to contain risky price fluctuations for enormous capitals.

Recommended Read:  What is Crypto Staking?

Hedging Through Futures Derivatives

Hedge funds invest in the market on the behalf of institutional investors and high net worth individuals (HNIs) and engage in hedging to contain risky price fluctuations for enormous capitals.

In the above example, we looked at the situation from the perspective of a retail trader.

Now, we will look at the market from the perspective of a large company.

Let's take MNO Chips Company itself.

MNO is worried that the agrarian crisis could lead to the prices of potatoes rising over the next few months.

One kilogram of potatoes costs $3 today. What if it rises to $8 after six months?

An upward price movement of potatoes could significantly limit the prospect of profits for the company.

In anticipation of the potential price rise, MNO decided to order a futures derivative with potatoes as the underlying assets for $1.

A futures derivative gives a trader the option to purchase the product at a specific price at a set date in the future.

The futures derivative MNO has ordered mandates it to purchase potatoes at $5/kg after six months. The company doesn't have to factor in price fluctuations for its future purchases of potatoes.

Now, there are two possible scenarios: either the potato’s price will rise, or it will fall.

In case the price rises to $8/kg after six months, MNO can still buy potatoes for $5/kg.

Remember that it already spent $1 on the futures. So, one kg of potatoes cost MNC $6.

Without a futures derivative, it would have cost MNC $8/kg.

Consider the scenario where instead of falling, the potato’s price falls to $2/kg after six months.

The company could have bought it for the same price, i.e. $2/kg if not for the futures which mandates that MNO is still required to purchase potatoes at $5 as per the derivatives contract.

If we add the cost of the futures derivative too, one kg of potatoes cost has MNC $6, instead of a mere $2.

Hedging Through Portfolio Diversification

A more common and simpler way of hedging is portfolio diversification.

The term is self-explanatory. If you have invested in automobile stocks, you can hedge against them by purchasing FMCG (Fast-moving consumer goods) stocks.

FMCG stocks tend to be resilient even in a dwindling economy; automobile stocks would most likely underperform in such economic conditions.

Portfolio diversification allows you to manage the risks associated with one sector by betting on another resilient sector.

However, portfolio diversification is also no guarantee against potential losses.

It is possible that both automobile and FMCG stocks might tank during a severe recession. Since no sector remains immune to recession, even portfolio diversification won’t help you in such stressful times.

Pros and Cons of Hedging

At this point, we should highlight both the pros and cons of hedging so that an investor can take a wise trading decision. 

What Should BitDelta Traders Know?

We recommend that BitDelta traders shouldn't engage in complex trading practises unless they are guided by reliable financial advisers.

Portfolio diversification is, however, a simple hedging technique for retail investors.

Nonetheless, we keep educating our users about trading strategies such as hedging because several large companies they are investing in engage in hedging techniques in strategic ways on an enormous scale.

Hedging impacts the portfolios of these large companies significantly and as a smart investor, you should keep abreast of such trends in the market.

Education, learning and experience are your best friends in your road to financial security.

BitDelta Academy is the best resource for financial literacy where we regularly post update about the latest market trends and trading practices.

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