Beginners’ guide to hedging strategies
Hedging is the practice of strategically opening new positions to protect existing positions from unpredictable market movements. Discover why hedging is such a popular strategy and the different ways that you can hedge.
What is hedging?
Hedging is the practice of holding two or more positions at the same time with the intent of offsetting any losses from the first position with gains from the other. At the very least, hedging can prevent a loss from going beyond a known amount.
In fact, you might’ve hedged and not even known about it as people hedge in everyday life as well as on financial markets. For example, people view insurance as hedging against future scenarios – as hedging will not prevent an incident occurring, but it can protect you if the worst should happen.
Typically, hedging is a risk management strategy used by short to mid-term traders and investors to protect against unfavourable market movements. Many long-term investors never use hedging as they tend to ignore short-term fluctuations altogether, but it is still important to learn about the process because it can have a range of different applications.
Why do traders hedge?
Traders might hedge their positions for a number of reasons; whether it’s to protect their trades, their investment portfolio or are looking to combat currency risk. It’s important to understand that when traders hedge, they do so not as a means of generating profit but as a way of minimising loss. All trading involves risk because there is no way to prevent the market moving against your position, but a successful hedging strategy can minimise the amount you would lose.
By way of example, here are four common reasons that traders choose to hedge. In no particular order, these are:
- To avoid volatility risk on forex positions
- To avoid liquidating shareholdings
- To avoid currency risk on foreign assets
- To avoid cryptocurrency risk
Avoiding volatility risk on forex positions
For some, the allure of trading forex is that it’s incredibly volatile and fast paced, but for others, there is a desire to reduce excessive risk where possible. While many traders will minimise their risk by attaching stop-losses, there are some that choose to use forex hedging strategies. These include:
- Simple forex hedging, which involves taking a long position and a short position on the same currency pair
- Multiple currency hedging, which involves selecting two currency pairs that are positively correlated, and taking positions on both pairs but in opposite directions
- Forex options hedging, which gives the holder the right, but not the obligation, to exchange a currency pair at a set price on a specific future date
Avoiding liquidating shareholdings
Although investors tend to focus on longer-term market movements, some will hedge against periods of economic downturn and volatility, as opposed to liquidating a shareholding.
As an investor, it’s also important to understand the process of hedging because it is a widely used strategy for businesses. So, if you’re investing in an oil company, for example, they might choose to hedge against declines in the price of oil by using futures contracts. Understanding hedging would make it easier for you to make sense of the company’s financial undertakings.
Discover how to hedge your share portfolio
Avoiding currency risk on foreign assets
Currency risk, or exchange rate risk, describes the potentially damaging impact that fluctuations in the value of a currency pair can have. There are a range of ways the term currency risk is applied but it is largely used to describe the negative effects of forex rates on the value of an asset that is being transferred across borders. The risk can apply to properties being sold overseas, overseas salaries and even currency conversion for holidays.
For example, if an individual was going on holiday to the US in six months’ time, they could opt to exchange their currency to dollars at the current rate or wait six months. While they might secure a better rate by waiting, they also might have to exchange at a worse rate – this is currency risk.
To combat currency risk, traders will hedge. Some of the most common ways to hedge currency risk include using options contracts, specialised exchange traded funds (ETFs) and leveraged products such as CFDs.
Avoiding bitcoin risk
Cryptocurrencies – such as bitcoin – are infamously volatile, and due to their deregulated nature, offer very little in the way of protection for traders. Although this volatility can provide a range of trading opportunities, it can cause concern for more risk-averse traders. This is why some traders choose to hedge their bitcoin positions using strategies such as short selling, or hedging with derivatives and futures.
Best hedging strategies
There are several methods that can be used to hedge, but some can be extremely complicated. That’s why we’ve taken a look at some of the most widely used ways of hedging against risk – whether this is a specific strategy, a platform function, or an asset class that is considered a hedge. These strategies are:
Direct hedging
A direct hedge is the strategy of opening two directionally opposing positions on the same asset, at the same time. So, if you already have a long position, you would also take a short position on the same asset.
The advantage of using a direct hedge, rather than closing your position and re-entering at a better price, is that your trade remains on the market. Once the negative price movement is over, you can close your direct hedge.
Let’s say that you have a short position on the FTSE 100, but you believe that the index is going to see a short-term rise in price as a result of a number of constituents releasing positive earnings announcements. In such an instance, you might decide to open a buy position on the FTSE to minimise your losses.
Normally, these two positions would net off, meaning that the first would be closed, but some trading platforms have a function that enables traders to ‘direct hedge’.
Pairs trading
Pairs trading is a hedging strategy that involves taking two positions. One on an asset that is increasing in price and one on an asset that is decreasing in price. Pairs trading creates an immediate hedge because one trade automatically mitigates the risk of the other trade.
The method involves finding two opportunities that are almost identical but are currently trading at irregular prices – one is undervalued, while the other is overvalued – then taking advantage of the moves toward the assets’ fair values. This strategy is most commonly used for share trading, but it can also be used to trade indices, forex and commodities, as long as there is a correlation between the assets in question.
If you wanted to choose two stocks to pairs trade, you’d likely look for two companies that are within the same industry, have similar financials and historical trading ranges. This strategy is not necessarily dependent on the direction that either trade will move in, but on the relationship between the two assets. It is considered a ‘market-neutral’ strategy, as it takes both a long and short position.
Trading safe havens
Safe-haven assets are financial instruments that tend to retain their value, or even increase in price, during periods of economic downturn. There are a range of assets that fall into the categories of both safe havens and hedges, such as gold.
Gold is considered a safe haven, as it has historically been investors’ go-to asset during times of financial crisis, but it is also considered a hedge against a drop in the US dollar. As the currency falls, it causes the cost of goods imported from the US to increase in price – this often results in many traders and investors using the safe haven as a hedge against this inflation.
In fact, research by Baur and Lucey found that gold is considered the best hedge against a potential stock market crash – as 15 days following a crash, gold prices have tended to increase dramatically due to their safe-haven status.1
Not all safe havens will be good assets for a hedging strategy, so it is important to do your research. But if you can use these well-known correlations to your advantage, they can be a good way to offset your risk.
How to hedge
As we have seen, hedging is achieved by strategically placing trades so that a gain or loss in one position is offset by changes to the value of the other. This can be achieved through a variety of strategies, such as opening a position that directly offsets your existing position or by choosing to trade assets that tend to move in a different direction to the other assets you are trading.
As there is a cost associated with opening a new position, you would likely only hedge when this is justified by the reduced risk. If the original position were to decline in value, then your hedge would recover some or all those losses. But if your original position remains profitable, you can cover the cost of the hedge and still have a profit to show for your efforts.
An important consideration is how much capital you have available to hedge, as placing additional trades requires additional capital. Creating a budget is vital to ensuring that you do not run out of funds. A common question is ‘how much should I hedge?’, but the answer will vary from trader to trader, depending on their available capital and attitude to risk.
The amount you should hedge depends on whether you want to completely remove your exposure, or only partially hedge a position. Hedging should always be tailored to the individual, their trading objectives and desired level of risk.
Calculating neutral exposure
Neutral exposure is the concept that a trader can completely offset risk by simultaneously being long and short in one or more markets. This is so an increase in one position offsets a decline in another. Essentially, traders can neutralise their risk by calculating their total exposure, and then hedging with a strategy that creates the same exposure in the opposite direction
Ways to hedge
Hedging can be carried out using a variety of financial instruments, but derivative products that take their value from an underlying market – such as CFDs – are popular among traders and investors alike.
There are a range of benefits of CFDs which make it suitable for hedging. Perhaps the largest advantage is that it do not require a trader to own the underlying asset to open a position, which means that traders can speculate on markets that are falling as well as rising. This is extremely useful when hedging, because to neutralise market exposure, traders need to be able to take positions in both directions.
There are two ways to start hedging, depending on your level of confidence and expertise. Your options are:
- Open an account. You can open an account with IG quickly and easily
- Practise trading on a demo account. Test your hedging strategies in a risk-free environment with an IG demo account
Alternatives to hedging
Although hedging strategies can be useful if you have a long-term belief that the market will rise or fall as you expect, they are not always beneficial. If you are unsure about a market’s future or can’t make a decision about how to hedge, then you might want to prepare for market risk by simply reducing the size of your position, or by not opening a position at all.
Alternatively, you could look to diversify your portfolio – opening positions across a variety of different asset classes. This way, you’ll be able to mitigate the risk that a decline in one position will wipe out the majority of your capital. By preparing your trading portfolio for the worst-case scenario, you’ll be able to reduce your need to hedge altogether.
Footnotes:
1 Baur and Lucey, 2007
