What is Hedging?

1 Feb 2021  Read 1201 Views

Complimenting your mom on the day of your results, helping your siblings when you need a favour, or praying to God on the day of a job result; these are some things we all do in life, whenever we come across a point where situations seem out of our hands. We hope that doing so will save us from the eventual risk of getting the worse outcome, right?

But, can you do the same when it comes to the stock markets? 

Well! The answer would be a big yes. And the term we are looking for is Hedging. In simple words, Hedging is the tool which an investor can use to save his portfolio from unwanted risks by employing different strategies. 

So, let’s get into the topic and find out how you can utilize it in your investing life.

Hedging against Risk 

When you buy a new car or a bike, you will tend to be super protective of it. You will ensure that no harm touches it. In the process, you will also buy insurance for the same; so that when things don’t go as you expected, your insurance will help you bear the losses sustained.  

This is a strategy we employ in every aspect of our life. We search for ways to minimize the probable risk. And stock markets are no different. 

The risk which you might be exposed to differs in their nature and place of origin. You might incur a loss due to industrial or sector performances of the stock you have purchased. Inflation and the constantly changing exchange rates also add a huge element of risk to your portfolio.

For instance, say XYZ company is coming up with high-grade plastic products which are gaining attention in recent times. You have invested in the stocks of XYZ, expecting good growth in the future. Unfortunately, the government then passes a new law which tightens the regulations on the production of plastic and XYZ is hurt very badly. As a result, the stocks fell, and you are forced to meet with a loss. 

As an investor, you could have offset the losses by shorting against the XYZ company. That way you would have neither made any loss nor would have gained anything. 

Though we make investments after a thorough analysis and study, at the end of the day, everybody knows that the future is uncertain. Hence, there is a high chance that your investment might perform contrary to your belief, thus bringing in huge profits or huge losses. And that is where Hedging comes into play. 

Hedging of stocks helps you to protect your portfolio, especially when the markets are not acting in your favour. However, the entire technique is easier said than done. You will be needing enormous knowledge and skill to employ it. 

Methods of Hedging

An investor might use a variety of tactics and techniques to offset the losses which they might incur. Most investors employ one or more than one to reduce the risk and maximize profits. Some of those are listed and explained in detail below.:

                                     

Diversification 

This is something that almost every article online might ask you to do. And despite its simplicity, its fruits are highly rewarding. Say you invested in the stocks of few hand-picked hotels. But due to Covid-19, your stocks saw a huge fall, thus fetching you an enormous loss. 

But then imagine another scenario where you utilized the idea of diversification. And say that apart from investing in hotels, you also invested in some med stocks and tech stocks. In that case, the risk might be reduced and the losses made will be done away by the profits which you will be making from the other stocks. 

Using the power of cash 

Here, the investor does not invest all of his money in one go; rather, he keeps a portion as just cash. He then uses it when he starts making losses. He uses the money as a hedge against the risk which he will be inheriting in case the outcomes are not favourable. 

Playing with an average price

Here, the investor buys some stocks; let’s say at Rs. 20, anticipating growth or an increase in the price of the same. But unfortunately, the shares fall drastically. He now purchases another stock of the same company at Rs.10. Now, the total value of the stocks left with him is 30. The stock market then saw a recovery with the price of shares touching Rs.16. 

In such a scenario, the investor might sell them pocketing Rs.2 as profit. The investor tries to play with the average price of the stock and tries to earn a minimal to 0 profit rather than inheriting huge losses. 

Short selling and put options

As mentioned in the above example, an investor may buy shorts as a way of insuring against future losses. For those who are puzzled as to what a short is, it is a strategy wherein you bet in favour of a fall in the price of a particular stock. 

On the other hand, the put option enables you to buy at a predetermined price in a future date. Say the stock of a particular company is consistently increasing from 50 to 60 to 70. You have purchased a put option for Rs. 70 and with an expiry period of 3 months. This means in the future, irrespective of how low the prices of the stock are, you can still sell them at Rs.70. 

Using Arbitrage as a Hedging tool  

This is a strategy wherein the investor purchases the stocks at a particular price from one place and sells the same stocks at a slightly higher price at a different place. Say Mr X purchased a stock for Rs.10 on BSE. He now sells it at a higher price on NSE of Rs.10.25. 

While this strategy is a good one, it does not suit every investor. Those who trade in bulk quantities usually employ this strategy as a way of Hedging. 

If you are still worried about the entire technique, you could simply get the help of a hedge fund who does this on behalf of you. 

In conclusion

While Hedging as such seems to be a pretty attractive concept, it is a calculative guess taken. And hence, is uncertain as well. There is no perfect formula or science to do away with the risk involved. 

However, this can be employed as an investment strategy only to reduce the level of exposure of risk, and to adapt to the one investment that best suits you.

About the Author: Varishika Dinesh | 136 Post(s)

Varishika is on the verge of successfully completing B.Com. Nothing excites her more than reading books and watching movies. Business, finance, economy? You have her attention.

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