What Is Hedging?

Hedging is a widely applied risk management strategy built to minimize potential losses from an investment or asset. Think of it as an insurance that protects your position against adverse price fluctuations.

For example, if you own a stock and expect its price to decline, you can buy a put option to safeguard yourself from potential losses. It is much like taking out an insurance policy on your investment.

Likewise, if a warehouse owner believes their goods are fire-prone, they would likely hedge that risk through an insurance policy, ensuring financial protection against possible loss.

Hedging isn't limited to financial markets. This concept applies across various domains. For instance, a business might purchase fire insurance to protect inventory. However, it is typically pursued only when the risk of a negative event is high.

In trading, hedging is a common practice across various markets and instruments - like stocks, commodities, or currencies. Essentially, investors buy or use another asset to offset the risk arising from their primary position, and that's precisely why derivatives also exist. It helps investors balance risk with a potential positive outcome.

Let's break it down with an example of hedging:

Example

Suppose an investor buys XYZ stock at ₹1000 but expects the company's upcoming results to be weaker than anticipated. He predicts that the stock price will likely fall after the quarterly announcement. Although he is mentally prepared for the dip, doing nothing won't prevent potential losses.

To protect himself, the investor buys a put option, anticipating the price drop. When the next quarter's results are announced, the stock indeed falls by 2%. However, because he had hedged his position using the option contract, the gains from the put option offset the losses in the stock.

In short, while one investment incurred a loss, the other compensated for it.

However, it's important to note that hedging doesn't always work. In another scenario, if the stock price doesn't fall as expected, the hedge would serve no purpose, and the premium paid for the option would be a cost of protection.

Generally, there are six common types of hedging strategies visible in each market. It includes;

Index Hedging

This strategy protects a portfolio from market-wide movements by taking positions in market indices like NIFTY or SENSEX futures.

For example, if you hold multiple large-cap stocks and expect the market to decline, you can short NIFTY futures to offset potential losses in your portfolio.

Option-based Hedging

It uses derivatives such as options or futures contracts to lock in prices or limit losses. It's more like a contra bet.

For instance, if you own shares of a company and expect a short-term dip, you can buy a put option to protect yourself from a fall in price.

Pair or Market-Neutral Hedging

Here, the investor may balance the risk by taking opposite positions in two correlated securities. One long and one short to benefit from the price difference rather than the overall market direction. It could be stocks of the same potential, peers, or competitors.

For example, you might go long on Infosys and short on TCS, expecting Infosys to outperform TCS even if the IT sector remains flat.

Currency Hedging

Traders prefer this type of hedge strategy to protect against fluctuations in foreign exchange rates, especially for companies or investors dealing in multiple currencies.

For instance, an Indian exporter expecting payment in USD might use a forward contract to lock in today's exchange rate and avoid future currency risk.

Interest Rate Hedging

With an aim to protect losses in debt securities, interest rate hedging helps manage the risk of rising or falling interest rates using tools like swaps or futures.

For example, a bond investor expecting interest rates to rise (which would lower bond prices) could short government bond futures to offset potential losses in his portfolio.

Cross-Asset Hedging

The cross-asset strategy involves using one asset class to hedge another, based on their inverse relationship.

Although hedging serves as a risk management tool, it has certain pros and cons. Let us look at it:

Over the years, hedging has been a daily ritual for many traders and investors. While it helps in offsetting any losses with another asset, the overall portfolio also benefits from it. But this strategy may not always be in your favour. Hence, it is necessary to understand the instrument and how it reacts to the market events.