The practice of hedging is one ever investor should utilize in their investment strategy. While hedging may be talked about quite a bit, that fact that it is never fully explained makes it seem as though only that most sophisticated investors can effectively use it.
That fact is that even novice investors can learn simple techniques for hedging with futures and options and what institutions and professional investors utilize to insure themselves from losses.
Hedging is a form of insurance against loss of capital. An investor who decides to hedge is insuring themselves from potentially negative events, reducing the impact these events could have on their investment portfolio.
While we utilize hedging everyday (think homeowners or auto insurance as a hedge against damage and accidents) in the financial markets it is not as easy as paying an insurance premium every month. When you hedge against an investment risk, you strategically use market instruments to offset the risk of negative price fluctuations.
While many investors dream of a world where there are limitless profit potential with zero risk, the reality of the risk-return tradeoff is that a reduction in risk will always translate into a reduction in gains.
Hedging is not a technique by which you make money, but rather an instrument by which you reduce potential losses.
These techniques for hedging usually involve the utilization of complex financial instruments known as derivatives. The most common types of derivatives are futures and options. When you are hedging with futures and options, you are implementing a strategy where you offset the loss in one investment with a gain in a derivative.
As an example, if you have a long-term position in a security that you believe may experience a bout of short-term losses, you can purchase a put option on that security that give you the right to sell that security at a specified price (the “strike price”). This strategy is referred to as a married put.
Your losses if the stock price falls below the strike price would be offset by gains in your put option.
A company that depends on a specific commodity can hedge against a potential rise in that commodity’s price by entering into a futures contract that permits the company to purchase that commodity at a specified price at a specified future date.
This strategy can backfire if the cost of the commodity falls, as the corporation would be required to pay the cost outlined in the futures contract. In the world of investing, even your insurance can carry risk.
Due to the amount of different futures and options contracts available, investors can hedge against almost anything, including currencies, interest rates, commodity prices, and stocks.
While there is an element of uncertainty in investing, risk is also essential in order to realize gains from your investing endeavors. Having the fundamental knowledge of hedging with futures and options will lead to a greater awareness of how institutional investors and corporations strive to shield themselves from losses.
Understanding the forces at play in the market will assist you in becoming a more successful investor whether or not you decide to utilize derivatives in your investment strategy.
You may also like:
- How To Invest In Oil Futures
- Can You Make A Living Trading Options?
- Conservative Options Trading For Capital Growth
- Online Trading Stock And Options
- Volatility Of Options: Use It To Your Advantage
- How To Choose An Online Options Brokerage
- The Risks Of Options Trading
- How To Build A Trading Plan For Forex