What is hedging in trading? – Guide for beginners

HEDGING IN TRADING EXPLAINED FOR BEGINNERS

Hedging is an important aspect to understand when entering the stock market. It can be a lifesaver when the markets sell off and you need to protect your positions.

Read on to learn more!

Hedging means protection

INTRODUCTION TO HEDGING

If you’ve ever sat at a blackjack table, you know that gut feeling when you see the dealer flip over his first card to reveal an ace. Oh no, she’s got 21″ for sure, you think as you stir your watery gin and tonic.

The casino knows you’re thinking the same thing – that’s why there’s a small print on the table that says “Insurance Pays 2-to-1”.

If the dealer’s first card is an ace, many casinos allow bettors to place an insurance bet on the side. The insurance bet pays 2-to-1 if the dealer ends up with blackjack, which happens about 33% of the time if the first card is an ace.

When the dealer turns over a blackjack, a player with an insurance bet loses the hand, but wins the side bet and reaches the break-even point. Of course, if the dealer turns over a 9, the player now runs the risk of losing both bets.

When an investor talks about hedging, he is talking about something similar to the insurance bet, offered to the blackjack player. Hedging is insurance against an adverse event, whether the dealer gets a 21 or the stock crashes 25%.

Investors can hedge their bets in a number of ways, many of which involve derivatives such as options and futures.

Hedging can help protect your assets during market downturns, but just like at the blackjack table, there are drawbacks. After all, hedging is inherently a bet against your own best interests.

What is hedging?

To clarify the issue, let me start with an example. A well-known hedge is when the USD loses value and gold increases in value. Many investors hedge by investing in gold when the USD is falling.

See the GOLD vs USD example below:

Hedge Gold vs USD

The orange graph shows the value of the USD. It can be clearly seen that gold rises when the USD falls.

Hedging has been a strategy in economics and investing for thousands of years, but sociologist Alfred Winslow Jones is credited with modernizing the concept. In 1949, Jones created a “hedged” fund to protect his clients from losses in the market.

Jones implemented his strategy by shorting stocks and increasing leverage, and thus the first hedge fund was born. Hedge funds today use a variety of different strategies to make money in all kinds of markets, but Jones’ original hedge fund simply wanted insurance against risk.

Hedging is still used by investors to protect themselves from downside risks, albeit using a variety of different methods. One of the simplest forms of hedging is the typical 60/40 stock and bond portfolio held in the retirement accounts of millions of Americans.

Middle-aged savers typically hold 60% stocks and 40% bonds, which results in lower long-term gains than a 90% stock portfolio, but also loses less money in a market drawdown (at least in theory).

As retirement approaches, these investors increase their exposure to bonds while decreasing their exposure to stocks.

If a crash occurs close to a person’s retirement age, a hedged portfolio of stocks and bonds will preserve the capital they have spent decades accumulating.

Day traders use much more complex strategies when hedging, but the thought process is the same. If a trader holding airline stock is concerned about oil prices or economic uncertainty, he may want to mitigate short-term risk without selling his stock.

To hedge the airline’s investment, the trader can place a separate order for a security that would appreciate if the airline’s stock declines. By hedging, the trader reduces the maximum possible profit on his original investment, but also preserves some capital if the shares crash.

How it works:

Hedging is an effective strategy in times of uncertainty because it removes a significant amount of the risk associated with an investment.

Hedging is everywhere – we have already referred to the well-known 60/40 stock and bond portfolio held by retirement savers. In a sense, all types of diversification are hedges.

That’s why a portfolio of 20 stocks is considered a safer investment than a portfolio consisting only of Amazon and Google stocks.

Should you hedge your investments if you are a day trader? That depends on your risk tolerance and your comfort level with using derivatives.

For a buy-and-hold investor, hedging is easy: ETFs, target-date funds and portfolio rebalancing are all easy ways to mitigate market risk.

However, if you want to hedge as a day trader, you need to learn to use more complex derivatives such as Options and Futures to use.

Simple hedging with short selling and the right strategy

Short selling is mostly used for hedging a portfolio. A simple strategy for this is to use CFDs with leverage. You can use them to quickly and easily build positions in any market. Short selling or normal buying is possible without any problems. In addition, there is always a direct cash settlement, so you can use the capital directly after ending the position.

I recommend the following brokers in the table below. With them you can hedge very easily in rising or falling markets. They offer trading CFDs on hundreds of markets. Benefit from very reasonable fees and a German service. It is possible to start with small capital and try trading.

Try a free demo account for yourself:

Trade with leverage
Easy trading on falling prices
Direct cash settlement
Stocks, currencies, commodities, indices and more
German service
Favorable fees
High liquidity
Go long and short at the same time

Advantages and disadvantages of hedging:

Advantage: Hedging can protect your capital in the event of a Black Swan event protect. When Lehman Brothers collapsed in 2008, shareholders were left with useless stock that had crashed at a fraction of its original price. Hedging can keep you in business if things go from bad to catastrophic.

Disadvantage: Hedging takes away some benefits from your trading. Minimizing risk doesn’t correlate with maximizing profit, so hedging is only worthwhile if you expect a sudden spike in volatility. If your investments are slowly chugging higher, hedging will be more of a liability than an effective protection plan.

Advantage: Investors with low risk tolerance can use a hedge to preserve not only capital, but peace of mind. It is said that investors often choose between two extremes – eating well or sleeping well. A high-risk investment portfolio might yield profits that allow investors to buy an expensive steak every night, but they might toss and turn at night thinking about uncertainty. Hedging allows investors to eat well from consistent gains AND sleep well at night knowing they are not taking on too much risk.

Disadvantage: Hedging is usually about buying one financial asset to offset the risk of another separate financial asset. As any trader knows, buying financial assets always involves transaction costs, even though commission-free trading is the norm today. If your hedging strategies are not well planned and executed, the capital you seek to preserve could be eaten up by fees and trading costs. Always consider both trading costs and estimated profits/losses when hedging.

Examples of hedging in trading

Diversification – The oldest and most well-known form of hedging is simple diversification. By buying a variety of different financial assets, your portfolio is not tied to any one security or industry. If tough times hit automakers and you hold GM and Ford, a portfolio balanced with technology and banking stocks could offset losses from auto stocks. Target-date funds are great examples of reducing risk through diversification.
Covered call options – A covered call is when you buy a stock while writing (i.e., selling) call options on the same stock. If you buy ABC stock with the goal of long-term price appreciation, you may experience flat trading periods in which the stock fluctuates within a defined range. If you expect this trading range to continue, you can sell a call option on the stock that provides income while your stock is trading flat. Note that this strategy can backfire during periods of high volatility, but using covered calls is one of the most common forms of hedging with options.
Out-of-the-Money Put Options – To protect stock holdings against an unknown negative event (or black swan), some traders choose to buy long-dated put options with a strike price well below the current stock price. These put options are attractive because they are cheap but almost always expire worthless. Unlike covered calls, out-of-the-money put options only save money if there is a serious market correction. Much like buying a “catastrophic” health plan, this strategy is cheap insurance against the worst case scenario. Just understand that you will spend 99% of your trading time bleeding profits out of the money with put options.
Hedge with commodity futures – Many industries depend on cheap commodities to keep prices low or profits high. When oil prices are low, airlines can fuel their jets cheaply. When the price of coffee skyrockets, Starbucks and Dunkin Donuts have to raise the price of their drinks at the same time. When companies have this kind of relationship with a tradable commodity, investors can use it to their advantage. If a trader holds shares of Southwest and Delta Airlines, he can hedge those holdings by buying oil futures. If oil prices rise rapidly, the airlines’ stocks will come under pressure due to increased fuel costs, but the trader will make money on the futures contracts.

My conclusion on hedging

Hedging your trades can prevent inflation and keep your positions manageable in times of uncertainty.

If a trade turns against you, a properly placed hedge can prevent you from losing most of your investment. But remember that hedging also comes with drawbacks and inconveniences.

When you hedge a trade, you must buy a security that moves in the opposite direction of your original investment. Not only does this lower your maximum profit level, but you also pay transaction costs for two trades instead of one.

Hedging a trade is buying insurance.

And like auto and health insurance, you need to decide what level of protection is right for you. Do you want to protect your assets with full coverage auto insurance or risk buying only state minimum coverage?

And likewise, do you want to just run your trades or do you want to take something off the top to preserve your capital? It’s a personal decision – there’s no right or wrong answer.

Just make sure you understand the pros and cons of hedging before adding it to your trading toolkit.

We will be happy to hear your thoughts

Leave a reply

⑇ CraftyFin
Logo
Reset Password
Compare items
  • Total (0)
Compare
0
%d bloggers like this: