Learn what hedging is, why it is important, and how to use different hedging techniques to reduce your exposure to market volatility and risks.

Derivative traders can be easily categorised into three groups (broadly speaking): hedgers, arbitragers and speculators. Hedgers use derivatives to protect the side they are worried about. Very simply, if someone is long, he will protect downside and vice versa. However, practical cases are not so simple and hence we see novel varieties of derivative instruments - bespoke one according to use cases. Generic ones are sold on exchanges and then there are Over-the-Counter (OTC) ones which are bilateral in nature and more often than not customised to suit the buy side

How can you use hedging to protect your investments from market volatility?

Market volatility can be a source of stress and uncertainty for investors, especially when it affects the value and performance of their portfolios. However, there are strategies that can help you reduce your exposure to market risks and protect your investments from adverse price movements. One of these strategies is hedging, which involves taking an offsetting position in a related asset or instrument to balance out the potential losses or gains of your original position. In this article, we will explain what hedging is, why it is important, and how you can use different hedging techniques to manage your risk in various scenarios.

1 What is hedging?

Hedging is a risk management technique that aims to reduce or eliminate the impact of unfavorable market movements on your investments. Hedging involves taking a position in a related asset or instrument that has a negative correlation with your original position, meaning that they tend to move in opposite directions. For example, if you own shares of a company that is sensitive to oil prices, you can hedge your position by buying a futures contract that allows you to sell oil at a fixed price in the future. This way, if oil prices fall, you can offset the losses from your shares with the gains from your futures contract, and vice versa.

Add your perspective

2 Why is hedging important?

Hedging is important because it can help you protect your investments from market volatility, which can be caused by various factors such as economic events, political developments, natural disasters, or changes in supply and demand. Market volatility can affect the value and performance of your investments, as well as your cash flow and liquidity. By hedging your positions, you can reduce your exposure to market risks and stabilize your returns. Hedging can also help you diversify your portfolio and take advantage of new opportunities without increasing your risk level.

Add your perspective

Gourav Kullu

Marine VDR Nav. Audits / Faculty I New Product Development (IIM Banglore) I Trader and BI Analyst.
Report contribution
Imagine this, there are two guys jumping off the aircraft. one with a parachute and the other without. eventually both would come down but the probability that the guy with parachute (hedged person) would take the next flight and fly high again is much higher than the guy who just jumped without a parachute.

Like

3 How to hedge with derivatives?

One of the most common ways to hedge your positions is to use derivatives, which are financial instruments that derive their value from an underlying asset or index. Derivatives can be used to hedge against various types of risks, such as price, interest rate, currency, or credit risk. Some of the most popular derivatives for hedging are futures, options, and swaps. Futures are contracts that oblige you to buy or sell an asset at a predetermined price and date in the future. Options are contracts that give you the right, but not the obligation, to buy or sell an asset at a specified price and date in the future. Swaps are agreements that allow you to exchange cash flows or payments with another party based on an underlying asset or index. Derivatives can be used to hedge both long and short positions, depending on your expectations and objectives.

Add your perspective

Piyush Chamria, PRM

Chief Risk and Compliance Officer, Edelweiss Global Markets
(edited)
Report contribution
Derivative traders can be easily categorised into three groups (broadly speaking): hedgers, arbitragers and speculators. Hedgers use derivatives to protect the side they are worried about. Very simply, if someone is long, he will protect downside and vice versa. However, practical cases are not so simple and hence we see novel varieties of derivative instruments - bespoke one according to use cases. Generic ones are sold on exchanges and then there are Over-the-Counter (OTC) ones which are bilateral in nature and more often than not customised to suit the buy side

Like
Vivek Royzada
Report contribution
Derivatives can be used for hedging open positions, as long as one has understanding on their precise nature and has calculated their payoffs at different levels. Plain vanilla structures might suit some positions, while customised strategies might be need of the hour for others.

Like

4 How to hedge with diversification?

Another way to hedge your positions is to diversify your portfolio, which means to invest in a variety of assets or instruments that have different characteristics and risk profiles. Diversification can help you reduce your overall risk by spreading it across different markets, sectors, regions, or strategies. Diversification can also help you improve your returns by capturing the benefits of different asset classes and market conditions. However, diversification is not a perfect hedge, as it does not eliminate all types of risks, such as systemic or market-wide risk. Therefore, diversification should be combined with other hedging techniques to achieve optimal risk management.

Add your perspective

5 How to hedge with insurance?

A third way to hedge your positions is to use insurance, which is a contract that provides you with protection or compensation in case of a specified event or loss. Insurance can be used to hedge against various types of risks, such as property, liability, or health risk. Insurance can also be used to hedge against specific events that can affect your investments, such as natural disasters, political instability, or terrorism. Insurance can help you reduce your potential losses and increase your confidence and security. However, insurance also has some drawbacks, such as premiums, deductibles, exclusions, and limitations. Therefore, insurance should be used selectively and carefully to balance the costs and benefits of hedging.

Add your perspective

Gourav Kullu

Marine VDR Nav. Audits / Faculty I New Product Development (IIM Banglore) I Trader and BI Analyst.
Report contribution
Option contracts are usually considered as an insurance to a portfolio or an investment in stocks. One can buy a Put option or Sell a Call Option, but in either case we need to consider the cost of the insurance which should never exceed the potential profits. This is what makes the choice tricky. Buying a put option may be cheaper but if the downward momentum of price is weak one still tend to loose the premium owing to theta decay. On the other hand Selling a call option, may be expensive but it surely covers the losses to a relatively good extent. Concluding, the key factor is MOMENTUM. if it appears to be high buy put or else sell call.

Like

6 How to hedge with asset allocation?

A fourth way to hedge your positions is to use asset allocation, which is the process of deciding how to distribute your investments among different asset classes, such as stocks, bonds, commodities, or cash. Asset allocation can help you hedge your positions by adjusting your exposure to different sources of risk and return. Asset allocation can also help you align your investments with your risk tolerance, time horizon, and goals. Asset allocation can be done in various ways, such as strategic, tactical, or dynamic. Strategic asset allocation is based on long-term expectations and objectives. Tactical asset allocation is based on short-term market conditions and opportunities. Dynamic asset allocation is based on continuous monitoring and adjustment of your portfolio. Asset allocation can help you optimize your risk-reward trade-off and enhance your portfolio performance.

Add your perspective

Sankar Sharma

Helps Traders and Investors Make their money work in the markets| Provides Trading Education|Independent Technical Analyst | Mentors Traders| Keynote Speaker | Market Strategist | Author
Report contribution
While derivatives are often used for hedging, not everyone is familiar with how to implement them effectively. Investors who are less acquainted with derivatives can alternatively consider using inverse ETFs, gold, and cash as effective hedging options.

Like

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

Add your perspective

How can you use hedging to protect your investments from market volatility?

1

2

3

4

5

6

7

1 What is hedging?

2 Why is hedging important?

3 How to hedge with derivatives?

4 How to hedge with diversification?

5 How to hedge with insurance?

6 How to hedge with asset allocation?

7 Here’s what else to consider

Investment Banking

Rate this article

Thanks for your feedback

More articles on Investment Banking

More relevant reading