Hedging is often said to be an insurance for your stock market investments. Just like how you would buy life insurance or accident insurance, it is meant to protect and safeguard at a time of difficulty. Let’s learn more about hedging and see how you can employ it to make sure your money and investments are protected.
What is hedging?
Let’s understand hedging through an example. Suppose you are investing in a fund for the long term as you have a strong belief in its potential. But at the same time, you are risk-averse in your own way and want to protect against the chances of a downfall. Here, to do that, you invest in a fund that is considered the opposite of the fund you have invested in. That means the opposite fund is going to have the exact opposite movements of the fund you have invested in. But this is often unrealistic as it is very difficult to find such extremities. Instead, you can put your money in options and futures.
Options and futures allow you to trade a stock on a future date at a set price. Here, an option will be suitable as there is no obligation. Instead, there is a premium you need to pay and that premium price is the maximum loss you will have to bear if you don’t exercise the option by the maturity date.
Through an option, you can set a contract to sell the units of the fund at a set price with the broker. Suppose the price goes down, you can still get some amount of money back using this agreement as the broker will buy your stocks at the said price on the said date.
Like this, you can use F&O trading to hedge your current investments and as said above, it acts as insurance for your bigger investments.
Benefits of hedging
- Hedging helps you protect your investment in the case of a major market crash. If the price of your securities goes down tremendously, you can use your hedging instrument to limit the amount of loss or in some cases, reverse the loss itself.
- It gives investors and traders with a lower risk appetite a chance to trade in stock markets. As there is insurance like protection on the other side, such investors can do riskier trades that they wouldn’t do otherwise.
Risks related to hedging
- The biggest risk is the loss of premiums or fees related to the hedge. For example, if you have chosen a put option and you didn’t exercise the same, you will lose the premium you paid for it. If you have chosen a futures agreement, you might have to oblige to the same, bearing a loss, but futures are rarely used in hedging. This money could also offset your total profits, especially if the options are for a longer-term and a number of options are scarce and hence the charge related to it is higher.
Hedging is one way to ensure that your valuable capital is always protected. You can easily buy options for the same using stockbroker accounts. The important thing here is to understand what investments require a hedge and what doesn’t. Happy investing!