When we speak of the stock market, there are often divisive thoughts about it. Some relate the stock market with risky ventures while some regard it as a perfect opportunity for long term wealth creation. The market dynamic is everchanging and the outcome is not always aligned with the prediction every time. This often puts an investor in a dilemma of whether to opt for the investment or not.
Simply put, the investment allows a person an opportunity for long term wealth generation whilst lessening the risks around and everyone wants a piece of it. But people are also fearful of the loss in case the market fluctuates. This is why any potential investor is always on the lookout for ways to secure themselves from any impending loss that may arise out of the fluctuations in the market. That is where hedging comes forth as a viable option.
Hedging is a widespread practice in the stock market and we here look to brief you about it. But first, we’ll start with what is a hedge. Read along.
What is the meaning of hedge?
Hedge as a word means ‘a way of protecting oneself against any financial loss or other adverse situation’. It’s an analogy that is related to developing ways to help reduce or control the exposure to any impending risk.
Hedging is something that we can relate do in our normal routine lifestyle. Taking insurance is also a form of hedging as it helps to mitigate any risks that may come up. For say, a person takes home insurance to cover against the natural disaster. For that, he pays a certain premium and if no such natural disaster occurs, he will not get the payout. That’s something he has to bear but in turn, he also gets to secure his home. By doing this he is using hedging to control the exposure to risk for any damage occurring to his home out of the natural disaster. That how’s the concept of hedging works around.
A hedge is one of the ideal moves against any risk and its something that’s not just limited to the stock market as we saw above. But we’re more focused on hedging in share market over here as our core area of concern.
What is Hedging in the Stock market?
On a common note, hedging is about controlling or lessening the risks. It’s a widespread strategy used by investors and alike who looks to maximize the gains and lessen any loss that may arise in the stock market. Many investors in the stock market use hedging to help protect themselves against the fall in the price of a specific stock or even portfolio of stocks. The stock market is filled with opportunities and equally brimming with risks. This is where utilizing various instruments strategically can help to balance the adverse risk in the market. This can be done by making another investment in a targeted way. That process is conducted as per the hedging strategies.
It’s one of the advanced techniques used in the stock market by the investors. And truth be told, the hedging technique is not just limited to the stock market as other areas like commodities and even on currencies.
Stock Hedging Example
For say you hold 1000 shares of a Company ABC bought at Rs 100 each. The share, for now, is trading at Rs 120 in the market. You can buy a put option contract for this so that you can rest assured about the loss if the share dips below the rate later on. Or you can also negotiate a future contract for Rs 125 each for this stock and sell it later on at that time.
Types of Hedging Strategies
There are broadly three different categories of hedging that is used along and they are:
- Forward Contract: Forward contract refers to the agreement of buying or selling the assets between two parties at a pre-determined rate on an agreed date. Forward contracts are used by many investors and traders alike who want to secure themselves against any impending loss in the future. This is normally a non-standardized agreement and is often a private or customizable contract between two parties.
- Futures Contract: This is a standardized agreement of buying or selling of assets at a defined price on the agreed date between two different parties. A futures contract is offered on exchange funds where people can partake in and secure themselves against any loss that may arise in the future.
- Money Markets: This refers to the part of the financial market where the short term debt investments are traded on. Most of the trades that occur here come with a maturity period of one year or less. Money markets hedge is normally conducted in for the highly liquid financial instruments like treasury bills, commercial papers, banker’s acceptance and more. This helps to cover the amounts and provides flexibility.
How to hedge in the stock market?
When it comes to hedging in the stock market, it’s about you can do so by these following ways:
- Asset Allocation: It refers to the method of diversifying the investor’s portfolio to create a balance in the portfolio. For say, you can develop a ratio based on your preference and diversify it accordingly. That helps to keep the portfolio in check and provide a hedge against any loss that may arise out of any investment instrument within the portfolio.
- Structure: It refers to the way of creating a balanced portfolio where you invest a certain portion into the debt-based instrument and the rest into the derivatives market. That helps to keep a steady route in your investment portfolio.
- Follow options based strategy: It refers to the way of utilizing the options, i.e. call and put features to help hedge the investment. Herewith the basis of call and put you can either trade-off your asset without having to suffer an impending loss.
Everyone intends to invest with a view to gain returns from it. But with the market being ever dynamic and changing, the risk cannot always be diminished. So to mitigate the risks and create a safe side for any investor, hedging comes forth as a great option. And it’s rightly used by plenty of investors around.