Hedging

Hedging in trading is one of the methods of managing a risk management strategy that allows you to insure against a possible loss.

Hedging is used by large funds and retail investors.

A portfolio manager hedges assets using derivatives.

Retail investors have a harder time; they use short positions to protect their investment portfolio. Hedging is not suitable for those who use passive long-term strategies, as it involves active intervention in the investment portfolio.

What Can Hedging Give?

Hedging provides an opportunity to protect capital from a possible large drawdown by partially compensating for losses in an unfavorable set of circumstances.

How Hedging Differs from Insurance

There is a significant difference between insurance and hedging — the first implies paying someone for taking the risk, and the second involves an investment position in trading. But, for example, when buying options, hedging really resembles insurance. By using hedging, an investor minimizes losses by capping potential speculative gains.

Through option-like insurance structures, you can effectively benefit in certain scenarios. For example, say you have booked an apartment from a developer, making a non-refundable deposit of 10,000 dollars to lock in the property. If the property price drops significantly, it may be better to forfeit that deposit and buy a similar property much cheaper.

Hedging is often an exchange transaction involving, as a rule, an intermediary — an exchange, unlike insurance.

Sometimes hedging is performed directly, for example, in the case of forward contracts.

Advantages and Disadvantages of Hedging

The main advantage of hedging is that it allows for more effective risk management of an investment portfolio compared to standard diversification. Diversification helps mitigate potential losses by spreading capital across different assets, but it cannot fully offset losses during periods of severe market decline.

Furthermore, the correlation between different instruments can vary significantly. Some assets move in the same direction, while others have a weak negative or virtually zero correlation.

For example, in the US market from September 2012 to September 2022, the correlation between gold and the stock market was approximately -0.02, while that of 20-year Treasury bonds was approximately -0.03. This means that even a well-diversified portfolio will likely suffer losses, albeit to a lesser extent, during a significant market decline.

Hedging allows not only to mitigate such losses but, in some cases, even to generate a profit. For example, opening a short position on a stock creates an instrument with a negative correlation to the underlying asset. If the stock price declines, the profit on the short position can offset the losses in the underlying portfolio. Using futures with a short position also provides the opportunity to generate income through leverage.

Hedging is popular not only among investors and traders, but also among companies. Businesses can use such strategies to protect against unfavorable changes in exchange rates, rising commodity costs, or falling prices for manufactured products.

However, hedging also has its drawbacks. First and foremost, it is an insurance tool, and any insurance has a cost. Using hedging positions requires additional expenses such as commissions, spreads, or premiums on derivatives. Furthermore, the constant use of hedging can reduce the overall portfolio return, as part of the profit will be used to protect against potential risks.

It is also important to consider that hedging is a complex tool that requires market understanding and proper risk management. For novice investors, it can be overly complex and even dangerous if used incorrectly.

Therefore, such strategies are most often used by experienced traders, professional investors, and companies that need to control specific financial risks.

When Not to Use Hedging

There is a widespread belief that hedging is most effective at the end of a bull market, when the first signs of a potential reversal appear, and at the beginning of a bear market, to protect capital from declines. However, in practice, determining the moment of a market cycle change is extremely difficult.

Even if most indicators point to an imminent market decline, a correction may begin much later or not occur at all. An investor who opens protective positions too early risks incurring additional costs and losing part of their potential profit if the uptrend continues.

This is why permanent hedging is not always suitable for long-term investment portfolios. It requires additional costs and can reduce overall asset returns. A more rational approach is to use hedging as a temporary risk management tool during periods of heightened uncertainty or before important market events, rather than as a permanent strategy for protecting against every possible downturn.

What are the Strategies and Methods of Hedging?

There are several approaches to hedging, differing in the instruments used, the degree of protection, and the method of constructing the protective position. The choice of a specific strategy depends on the investor’s goals, portfolio structure, and the nature of the risks.

Direct Hedging

Direct hedging involves opening an offsetting position in the same asset held in the investment portfolio. For example, an investor owns a company’s shares and opens a short position in the same shares through a futures contract or CFD.

If the price of the underlying asset declines, the loss on the primary position is partially or fully offset by the profit from the hedging position. This approach reduces portfolio volatility and preserves assets during a temporary market downturn.

Theoretically, opening a position of the same size can completely neutralize the impact of price movements. However, in practice, commissions, spreads, holding costs, and possible limitations of the instruments used must be taken into account.

Cross Hedging

Cross hedging is used when an investor is unable or unwilling to open an offsetting position on the underlying asset itself and chooses another instrument with a high correlation.

For example, an oil producer might use oil futures to hedge against price changes, while a technology investor might partially reduce risk through a short position on the Nasdaq stock index.

The main risk of this approach is that the chosen instrument will not always move perfectly in sync with the underlying asset. The weaker the correlation, the less effective the protection will be.

Full and Partial Hedging

According to the degree of risk coverage, hedging can be:

Full — when the offsetting position completely offsets possible changes in the underlying asset’s value.
Partial — when the investor protects only part of the portfolio or uses a smaller offsetting position. This option is used more often, as it allows for reduced risk while maintaining the opportunity to profit from market growth.

Static and Dynamic Hedging

Static hedging involves opening a protective position once and maintaining it without significant changes for a specified period.

For example, an investor might open a short position on an index before the release of important economic data to reduce the risk of a possible market decline.

Dynamic hedging requires continually adjusting the protective position based on changes in the underlying asset’s price and market conditions.

For example, if the asset’s price continues to rise and the investor maintains a short position, the effectiveness of the protection decreases. In this case, the hedge amount may need to be revised.

Hedging Using Different Instruments

Various financial instruments can be used to protect a portfolio:

Futures are one of the most common hedging methods, allowing you to lock in the future price of an asset.
Options provide the right to buy or sell an asset at a specific price, limiting potential losses.
Forward contracts are primarily used by companies to protect against changes in exchange rates or commodity prices.
ETFs and inverse ETFs allow you to profit from a decline in the value of a specific market or sector.
Swaps are used to manage currency, interest rate, and other financial risks.

Risk-Based Hedging

Depending on who wants to protect themselves from price changes, there are:

Buyer’s Hedge — used when the buyer wants to protect themselves from a rise in the price of a future purchase. For example, an airline might lock in the price of fuel in advance.
Seller’s Hedge — used when the seller wants to protect themselves from a fall in the price of a commodity. For example, an agricultural producer might lock in the price of a future delivery in advance.

Anticipatory Hedging

This type of hedging is used before the underlying transaction. An investor or company opens a protective position in advance, anticipating a future price change.

For example, a company might plan to purchase raw materials in a few months and purchase futures in advance to protect against a possible price increase.

Pure and Cross Hedging by Asset Type

Pure hedging involves using the same asset held in the portfolio. For example, protecting a gold position with gold futures. Cross hedging is used when using a different, but related, asset. It is less precise, but is often the only available option.

Conclusions

Thus, hedging is a set of risk management techniques that allow investors to limit potential losses, reduce portfolio volatility, and better control the impact of adverse market movements. However, the effectiveness of any strategy depends on the correct choice of instrument, the size of the defensive position and an understanding of the existing risks.

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