Hedging
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Hedging involves making an investment with the goal of reducing the risk associated with negative price movements in an asset. Generally, hedging entails taking a counteractive position in a related security. Essentially, this means making simultaneous bets on both declining and rising prices.
Therefore, hedging is a strategic approach aimed at mitigating risks linked to financial products. This strategy bears resemblance to obtaining insurance, which lessens risk but also trims potential profits, considering insurance usually comes with a cost. To effectively hedge in the realm of investments, one must strategically employ various tools to offset the risk of unfavorable market price shifts. The most effective strategy entails making calculated and controlled additional investments.
One form of hedging in the investment world pertains to derivatives. Derivatives are financial instruments that mirror the performance of one or more underlying assets. These include options, swaps, futures, and forward contracts. While underlying assets can be usual stocks or bonds, they can also encompass more diverse items like commodities, currencies, indices, or interest rates. Derivatives can operate as efficient protective measures against these underlying assets, as the correlation between the two is commonly well-established. Furthermore, derivatives can enable a trading approach where potential losses in one investment are tempered or offset by gains in a corresponding derivative.
For instance, consider an investor who purchases 50 shares of a company at CHF 50 per share. This investment could be hedged by acquiring an American put option with an exercise price of CHF 40 and a one-year term. This option provides the right to sell 50 of these shares at CHF 40 anytime within the next year. Assuming the option costs CHF 10 per share, or CHF 500 for 50 shares, if the stock trades at CHF 60 a year later, the option will not be exercised. Thus, the investor loses CHF 500 but also gains CHF 500, as the price of the 50 shares has increased by CHF 10 per share. At this point, the investor neither gains nor loses. However, if the stock drops, say, to CHF 30, the investor can exercise the option. Consequently, the investor sells the 50 shares for CHF 40, thereby mitigating the loss.
For most investors, the practice of hedging will likely never factor into their financial activities. It is unlikely that many investors will engage in derivatives trading at any point. This is partly due to the fact that investors with long-term strategies, such as individuals saving for retirement, generally tend to overlook the day-to-day fluctuations of a specific security. In these cases, short-term ups and downs are inconsequential, as investments are likely to grow in line with the overall market.
For investors falling under the "Buy and Hold" category, there may be little incentive to delve into the intricacies of hedging. However, given that large corporations and investment funds frequently employ hedging strategies, and these investors closely monitor or even participate in the activities of these major financial entities, it is advisable to grasp the concept of hedging.
In addition to derivatives, there are other hedging strategies. Investors should not rely on just one strategy but rather use various ones to achieve the best results. The following are some hedging strategies that investors can consider. Additionally, spread hedging will be explained, which serves as another example of hedging using derivatives.
What is Spread Hedging?
Moderate drops in prices are common in the world of indices. In such cases, a Bear Put Spread is a useful hedging strategy. The index investor buys a put option at a higher strike price, and then sells a put option at a lower strike price, both with the same expiration date. This approach provides price protection within the difference between the two strike prices. While this protection is limited to the difference, it's generally sufficient for moderate price fluctuations.
Diversification
The saying "Don't put all your eggs in one basket" never gets old, and it holds true in the financial domain as well. Diversification means an investor spreads their investments across assets that don't move in the same direction. Simply put, it involves investing in a variety of assets that aren't closely related, so if one asset declines, others might rise. For example, an investor aiming to profit from a luxury goods company's rising margins could hedge by buying tobacco or utility stocks. A recession, for instance, might affect luxury goods sales, but it might have a lesser impact on tobacco consumption as only a few smokers would quit due to a recession.
Arbitrage
Arbitrage involves buying a product and immediately selling it at a higher price on another market. This allows the investor to make small but steady profits. This strategy is commonly used in the stock market. Let's take this example for illustration. Someone buys a jacket in the USA because the brand of the jacket is traded at a lower price in the USA compared to Europe. The person brings the jacket to Europe and sells it to a friend for a higher price.
Average Down Strategy
With the average-down strategy, more units of a specific product are purchased even though the cost or selling price has decreased. Stock investors often use this strategy to hedge their investments. If the price of a stock they previously bought drops significantly, they buy more shares at the lower price. If the price then rises to a point between the two purchase prices, the gains from the second purchase can offset the losses from the first one.
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