In this article we are going to talk about one of the most popular strategies to limit risk in trading operations, the heading or hedging. Read on to learn how to implement this valuable tool in your investments.
What is Hedging in Trading?
Hedging consists of opening opposite positions to offset possible losses. In other words, diversifying a portfolio with assets in different markets or with negative correlations. In this way, no matter which way the market moves, you will be able to perceive minimal gains or losses; limiting the risk in each of the open positions.
Examples of Hedging Strategies
Heading can be applied in a variety of ways, there are many hedging strategies and each one varies depending on the particular trader’s portfolio. Some of the most common include the use of futures contracts, financial options and positions in currency pairs.
Forex Hedging Strategies
Hedging strategies in the foreign exchange (Forex) market are tactics used by traders and investors to hedge against currency risk and reduce exposure to adverse movements in currency exchange rates. Â
Forward contracts: Forward contracts allow market participants to lock in an exchange rate for a future transaction. For example, a company can secure a forward contract to convert a specific amount from one currency to another at an agreed-upon exchange rate at a future date, thereby protecting against exchange rate volatility. Â
Currency Options: Currency options offer investors the right, but not the obligation, to buy or sell currencies at a specified price at a future date. For example, an investor can purchase a put option that allows him to sell a specific amount of a currency at a predetermined price, which protects him against the depreciation of that currency. Â
Concurrent Trading: This strategy involves opening opposite positions in correlated currency pairs. For example, if an investor has a long position in EUR/USD, he could simultaneously open a short position in USD/CHF to offset potential losses in the event of unfavorable EUR/USD movements. Â
Use of Correlated Pairs: Investors can identify currency pairs that tend to move in opposite or similar directions due to historical correlations. By opening positions in correlated currency pairs, they seek to reduce the risk associated with unfavorable movements in one of the currencies.
Example
Suppose an investor is long EUR/USD and expects the euro to weaken against the US dollar. To mitigate potential losses, the investor can open a short position in the correlated USD/CHF pair, as historically these two pairs have shown an inverse correlation. This strategy seeks to offset losses in EUR/USD with potential gains in USD/CHF.
Equity Hedging Strategies
Equity hedging strategies are methods used by investors to reduce the risk associated with holding stocks and protect against possible unfavorable movements in stock prices. These strategies seek to mitigate the risk of loss by taking positions that offset the inherent risk of stock investments.
Short Selling: Consists of selling borrowed shares with the expectation of repurchasing them later at a lower price. For example, if an investor owns shares of a company and expects the price of those shares to fall, he can sell them in the market and buy them back later at a lower price, thus making a profit on the difference. Â
Put Option Purchase: Investors can purchase put options that give them the right, but not the obligation, to sell shares at a predetermined price at a future date. If the stock price decreases below the put option exercise price, the investor can exercise his right to sell the shares at a higher price. Â
Stock Collar: This strategy involves the purchase of put options to protect the stock and the simultaneous sale of call options to generate income and reduce the costs associated with the purchase of the put options. This limits both the potential for loss and gain. Â
Simultaneous Trades in Correlated Stocks: Investors can take opposite positions in stocks of correlated companies. For example, if an investor holds shares of a telecommunications company and anticipates a decline in the sector, he can take a short position in another company in the same sector to offset potential losses.
Example
an investor owns shares of a manufacturing company and believes that the sector will face difficulties in the future due to changes in the economy. To protect his investment, he decides to purchase put options on those shares. If the stock price falls, the put options will allow him to sell the stock at a predetermined price, thereby limiting his losses.
Correlation Hedging Strategies
Correlation hedging strategies seek to reduce risk by identifying and taking advantage of correlation relationships between different financial assets, such as currency pairs, stocks or other financial instruments. These strategies are based on the historical relationship between two or more assets, either to mitigate potential losses or to seek profit opportunities.
Example
Suppose an investor has a diversified portfolio that includes shares in two companies in the same industry. It is historically observed that the stock prices of these two companies have a strong positive correlation, i.e., they tend to move in the same direction.
If the investor is concerned about an event that could negatively affect the overall sector, but is unsure which of the two companies will be more affected, he might consider taking a short (sell) position in futures on a sector index rather than selling his shares in one of the companies.
By doing this, if the event affects the overall sector and the stock price of both companies declines, the short position in the sector index futures could offset the losses in the value of the individual companies’ shares, as the strategy benefits from the positive correlation between them.
Ventajas y Desventajas del Hedging en Trading
| Ventajas del Hedging en Trading | Disadvantages of Hedging in Trading |
| Helps mitigate risk: Reduces exposure to adverse market movements. | Associated costs: Implementing hedging strategies may generate additional expenses, such as commissions and transaction costs. |
| Protects investments: Allows limiting potential losses in case of unfavorable price movements. | Reduced profit potential: By hedging against losses, you also limit the potential for maximum profits. |
| Provides peace of mind: Investors feel more secure by having hedging strategies that protect their investments. | Complexity and difficulty: Some hedging strategies can be complicated to understand and execute correctly. |
| Risk management flexibility: Allows investors to adjust their risk exposure according to market conditions. | Potential overuse: Excessive hedging strategies can lead to inefficient capital management. |
| Adaptability to different markets: Can be applied in various financial markets, such as equities, currencies and commodities. | Psychological impact: Some investors may be frustrated by the limited profit potential due to hedging. |
Hedging in Trading vs. Speculation
Hedging focuses on risk management and the protection of investments against potential losses. Investors use hedging strategies to reduce risk exposure, usually by opening opposite positions that act as insurance against unfavorable market movements. The main objective of hedging is to preserve capital and minimize losses, rather than to seek speculative profits.
Speculation, on the other hand, involves taking risks with the primary objective of making profits based on future market movements. Speculators take positions in the hope of capitalizing on market volatility and earning significant profits. Unlike hedging, speculation does not seek to protect against losses, but rather to take advantage of opportunities to profit.
| Trading Hedging | Speculation |
| Protection against risks and losses | Pursuit of profits and returns |
| Strategies to reduce risk exposure | Risk-taking in search of higher returns |
| Focus on capital preservation | Focus on profit maximization |
| Lower earning potential, but with lower risk | Higher earnings potential, but with higher risk |
