Hedging Strategies You Should Know

What a hedging strategy does is to show you specific ways, using the right instruments or tools to effectively curtail your losses.

One thing we can all agree of is that sometimes, it is better to cut your losses by minimizing risk. As an investor, hedging your investment against possible losses is a great way to do so. We had earlier highlighted some of the types of instruments used to hedge like forward contracts, future contracts, and the money market.

What a hedging strategy does is to show you specific ways, using the right instruments or tools to effectively curtail your losses. Just as the market is volatile, so are the hedging techniques as well.

As such, it is important to note that the hedging strategies are to be applied based on the financial asset in question, the time, and based on all other factors peculiar to the investment. As a guide, here are some of the popular hedging strategies.

Hedging Via Asset Allocation

Diversifying your portfolio as an investor is part of the hedging process and it can be used to spread your risk to varying degrees depending on your requirement. You can diversify your portfolio into asset allocations that carry risk and assets that provide stable returns and balance their portfolio.

Rather than having your basket full of volatile assets, you can spread your investments over various investment types, having various risks. For example, rather than having 100% risky assets, you can invest 60% in stocks and the remaining 40% in stable assets, to create a balanced portfolio.

Because risk is reduced, your average investment returns on the portfolio if the hedged investment indeed does well, you will lose profits from the new dilution. However, where losses occur, hedging through a diversified portfolio would help you come out safe.

Hedging via Portfolio Structuring

The way the hedge is structured is also another hedging strategy you can employ. It helps to invest a portion of your portfolio in debt and others in derivatives and this is because while debt gives stability unlike equity investments which are volatile, the derivatives would protect your portfolio from risk.

Hedging via Arbitrage

The concept of arbitrage is employed as a means of making profit by exploiting price differences of identical or similar financial instruments. These instruments are also typically traded on different markets.

To do this, the investor has to take opposite positions on two markets. The goal is for him to be able to hedge physical pricing on different markets for the same or similar products.

Hedging via Price Fixing

This is common when using forwards or futures, where an investor sets the price he wants to trade at. Assuming the price of a commodity hits an all-time high, the investor can lock the value at that price point.

If it reduces, he still gains from the high price that had been pre-set. However, where the price further increases, he has to forfeit all the additional benefits. Price fixing involves taking advantage of the current market levels for future transactions.

Hedging Via Stop-Loss Orders

Sometimes, the only aim is to curb your losses. A stop-loss order is as the name implies. It is a directive that is given to your broker to sell your shares if the price declines to a predetermined level. Where major loss is expected, the order shields you from the full effect of it.

Written by Lawretta Egba.