What Is Hedging? How To Limit Your Losses With Hedging?

A Common Dilemma

Don't you wish you had sold your loss-making shares earlier? Or that you had bought a bullish stock earlier?

That would have lowered your losses or improved your profits.

Well, this can be done by hedging your portfolio or applying hedging as an active part of your investing strategy.

This article will explore what hedging is, how it works in the stock market, along with the strategies, advantages, and disadvantages of hedging.

What Is Hedging?

Hedging is a financial strategy in which you take an offsetting position to reduce risk and limit losses. The goal of hedging is to limit potential losses while allowing for potential gains.

You can hedge multiple assets, including stocks, commodities, currencies, interest rates, etc.

Not only individuals but also companies can hedge different commodities or assets. One popular example is of hedging petrol prices.

As a petrol-dependent company, you might be afraid that the prices of petrol might rise shortly, leading to a change in the company's financials for the worse. So to hedge against that risk, you, as a company, can enter a futures contract that fixes the buying price of the petrol for that company.

It means that irrespective of the price decline/rise of petrol, you must buy it at the mentioned price in the contract. This type of hedging will be profitable in case of a price rise. However, it will be loss-making in case of a price drop.

What Is Hedging In The Stock Market?

In the stock market, hedging involves taking an opposite position in an asset to offset potential losses in a particular stock or portfolio.

For example, you might buy put options on a stock you own, allowing you to sell it at a predetermined price if it falls below that level. This would limit your potential losses if the stock declines.

Similarly, you might buy a call option and buy the stock at a predetermined price if the stock were to rise. If you are scratching your head, don't worry. It's explained further below.

Example of Hedging

One example of hedging is using put options to protect a stock portfolio from potential losses.

Consider you own Adani Green stocks valued at Rs 2000, and due to the recent Hindenburg Report, you are not sure of the stock's possible upward or downward movement.

In such cases, you can hedge your position to limit your losses through a Put option, which gives you the right, but not the obligation, to sell the stock at a predetermined strike price.

If you had created a hedge position by buying a put option of Rs 1900, then irrespective of the value of the stock today (~Rs900 ), you could have sold your share of Adani Green for Rs 1900 and thus limited your losses.

Types of Hedges

Some of the techniques that you can use for hedging include:

• Derivatives: Some popular derivative instruments, like futures and options, can open a contradictory position to your original position to limit losses. With these instruments, you can participate in strategies with put and call options or a combination of them, which can fix the buy/sell price of a commodity/stock to limit the losses and lock in the profits (if any).
• Diversification: Diversification can be regarded as a hedging strategy that limits your exposure to a particular company as you spread your bets across multiple companies within the same industry or sector. However, in the case of a broad market meltdown, most companies will go down, despite their strong fundamentals.

Advantages of Hedging

Now that you understand the types of hedging let’s learn about the advantages of it.

1. Reduced Risk: Hedging reduces the risk of loss in your portfolio. By entering into a hedge, you are taking a position that offsets the risk of your position in the portfolio.
2. Increased Certainty: By locking in prices or rates in advance, you can better plan for the future and avoid the uncertainty of market fluctuations.
3. Diversification: Hedging can help you diversify your portfolio by investing in various assets, thus reducing risk.
4. Improved Returns: By reducing your risk of loss, you may achieve more consistent returns and avoid significant losses that can set you back.  

Disadvantages of Hedging

While hedging can help investors reduce risk, it is not without risks. Some of the risks involved are,

1. Complex: Hedging strategies can be complex and require high expertise to implement successfully.
2. Limit Gains: Additionally, hedging can limit potential gains by taking opposite asset positions.
3. Increases Costs: Finally, hedging strategies can be costly as they often involve using derivatives and other financial instruments.

When and How to Hedge?

If you foresee a crash in the market, consider the possibility of hedging your portfolio to limit the losses or even be profitable doing that. You can follow the below steps to prepare for hedging.

1. Identify the assets at risk: Some of the investments in your portfolio will be more exposed to the event and, hence, more affected in the event of a crash. You can easily shortlist these assets by checking the Beta for these stocks. Then, identify these assets to create a hedging strategy tailormade for them.
   
2. Choose the hedging strategy: Depending on the assets at risk(stocks) and the risks, i.e., the premium you can afford, you should choose the hedging strategy.
   
3. Determine the strike price and contract expiration date: Setting the strike price to trigger the contract terms. These are often decided based on your investment goals (short/long), based on which you can select the contract's expiration date.
4. Calculate the premium: As mentioned earlier, your can hedge your investments at the cost of a certain premium which will vary. It is essential to consider the cost of the premium and the commission/fees (if any) before hedging your assets, as it can increase losses instead.
   
5. Implementing the strategy: This step involves implementing the selected hedging strategy. Again, you can use free tools like Sensibull, Opstra Definedge, etc., to help you test the options strategies in real time.

Should You Consider Hedging Your Investments?

Whether or not to hedge your investments depends on your investment goals, risk tolerance, and level of expertise. If you are concerned about potential losses in a particular stock or portfolio, hedging may be helpful. However, if you are comfortable with market volatility and have a long-term investment horizon, hedging may not be necessary.

If you are interested in Hedging and have a stable equity portfolio in place, you should learn more about our Nifty Rider Model, which is based on trend following. The model is designed for risk-taking active investors who want to hedge their investments on the downside and make money on the upside. You can learn more about our free model here.

Frequently Asked Questions (FAQs)

Q: What is the best way to hedge my investments?

A: The best way to hedge your investments depends on your specific circumstances and investment goals. Speak with a financial advisor to determine the best hedging strategy for you.

Q: How can I learn more about trading and hedging?

A: On Investmint, we have a curated list of blogs to help you understand hedging and trading strategies.

Q: Can hedging guarantee that I won't lose money in the stock market?

A: No, hedging cannot guarantee that you won't lose money in the stock market. It can only help mitigate potential losses.

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