What Is Hedging & How Does Hedging Work?

Portfolio protection is just as important as portfolio appreciation. That’s where hedging comes in. Often seen as a safety net for your portfolio, hedging helps manage risk when the market takes an unexpected turn. In this article, we will discuss what is hedging in the stock market, how it works, and its advantages and disadvantages.

What Is Hedging?

Hedging is a strategy for risk management that involves taking an offsetting position in a related security to protect your existing investments against adverse price movements. In simple terms, it is like an insurance policy for your investments. The core of hedging in stock market revolves around minimising potential losses, even if it might limit possible gains.

How Does Hedging Work?

Hedging works on the principle of negative correlation. When you hedge, you essentially create a position that moves in the opposite direction to your primary investment. If your main investment loses value, the hedge position gains value, thereby offsetting some or all of the loss.

For instance, if you own shares of a company and worry about a potential price drop, you might buy put options on those shares. These options increase in value when the share price falls, compensating for the loss in your stock holdings.

Popular Hedging Approaches for Indian Investors

Various strategies exist under this method for different market conditions and investment objectives. Here are some of them:

Derivatives-Based Hedging

Derivatives hedging techniques involve using futures, options, and swaps to offset potential losses in your primary investments. For example, if you hold ABC Industries shares, you might buy put options that give you the authority to sell those shares at a given price, protecting against significant downside.

Diversification Across Assets

One of the simplest forms of hedging involves spreading investments across different asset classes that do not move together. When equities perform poorly, gold or government bonds might perform well, balancing your overall portfolio performance.

Currency Risk Protection

For businesses with international exposure, currency hedging for businesses becomes essential. Companies engaged in import-export activities often use forward contracts to lock in the exchange rates and safeguard profit margins from currency fluctuations.

Interest Rate Hedging

Companies with large loans use interest rate risk hedging to protect against rising interest costs. This might involve swapping floating-rate loans for fixed-rate obligations through derivative contracts.

Advantages of Implementing Hedging Strategies

This strategy offers several benefits to investors and businesses, as outlined below:

• Portfolio risk management becomes more effective, allowing you to maintain your investment positions even during market turbulence
• For businesses, hedging can stabilise cash flows and protect profit margins against commodity price swings or currency movements
• Market volatility protection through hedging enables long-term investment strategies without panic selling during downturns

Limitations and Challenges of Hedging

Despite its benefits, hedging comes with certain drawbacks, such as:

• The cost can be significant and might reduce your overall returns, especially when markets move favourably
• Complex strategies require advanced knowledge and might be difficult for beginners to implement effectively
• Perfect hedges rarely exist, leaving some residual risk that cannot be eliminated completely

Real-World Hedging Examples

Consider an Indian tea producer who exports the products globally. This business faces risks from fluctuating tea prices and changing rupee-dollar exchange rates. The company might use commodity futures to lock in tea prices and simultaneously engage in hedging in forex trading through forward contracts to secure exchange rates.

Similarly, mutual fund managers practise hedging in the stock market during uncertain times by purchasing index put options that increase in value when the market falls. This helps protect their equity portfolios from steep declines.

How To Implement a Hedging Strategy?

To start hedging in trading, first identify your specific risks. Are you concerned about overall market decline, individual stock performance, or currency movements? Once identified, select appropriate hedging instruments like options, futures, or inverse ETFs.

Remember that hedging is not about eliminating risk completely but managing it effectively. Start with simple strategies before moving to more complex approaches. 

Comparing Different Risk Management Approaches

Hedging differs significantly from speculation and arbitrage. While hedge fund managers might use all three, they serve different purposes. Here are some key distinctions.

Final Thoughts

Hedging represents a prudent approach to managing investment risks rather than eliminating them entirely. While perfect protection does not exist, effective hedging enables more confident investing even during uncertain times. 

Ready to apply hedging strategies to protect your investments? Open a 3-in-1 account with Torus Digital today. Our online trading platform provides all the resources you need to implement different hedges effectively.