How Do Hedging Strategies Work?

All trading involves some element of risk – the key is to manage it. One tried-and-true tactic to protect your positions from market fluctuations is hedging. What is hedging, and how does it work? We’ll discuss the hedging meaning below, along with a few of the reasons why hedging strategies are so popular.

What is hedging?

The hedging meaning in finance refers to holding two or more open positions when trading. If there are any losses from your first investment position, you’ll be able to offset these with gains from the second. This helps protect your overall portfolio from the impact of unexpected risk. It’s a way to limit losses by ensuring that there is a backup plan in place.

One common UK hedging strategy used outside of finance is the act of purchasing an insurance policy. For example, you might purchase contents insurance for your property that pays out in the event of theft or natural disaster. The insurance itself won’t prevent these things from happening, but it will protect your finances if anything happens to your property.

Hedging strategies in finance work using the same risk management principles as insurance. If the market takes a sudden downturn, the hedged positions can offset any loss.

Examples of hedging

Hedging protects against financial loss, but what does this look like in practice? Here are two common examples of how traders put common UK hedging strategies to good use.

1. Hedging with currency trading

Trading foreign currencies involves a high level of risk due to market volatility and swiftly changing conditions. There are numerous hedging strategies that Forex traders use to try and minimise this risk, including taking opposite positions on two currency pairs with a positive correlation. Another option is to take both a long and short position on the same pair of currency. Whichever direction the currency moves, you’ll have your bases covered.

2. Hedging with derivatives

Hedging strategies are often employed with derivative financial instruments, such as options and futures. The idea is that if one investment loses, the derivative offsets this with a gain. For example, imagine that you own shares in Sally’s Protein Bars (SPB). Due to a volatile market, you’re worried about short-term losses in the health food sector. To offset this, you can purchase a put option which gives you the right to sell SPB at a specific strike price. If the stock plummets below the strike price, the put option gains to offset the risk.

Common hedging strategies

We’ve covered a couple of hedging strategies using the examples above. With multiple types of stock options and futures contracts, you can apply this principle to hedge against interest rates, currencies, commodities, or stocks. Here are three common strategies:

1. Direct hedging involves opening two opposing positions on a single asset at once. You could open a long and short position on the same asset, for example. This is a straightforward hedging technique that’s easy to follow.

2. Pairs trading is another common strategy that also involves taking two positions, but this time it involves two different assets. One position should be taken on an asset that’s gaining in price, and the other on an asset that’s decreasing. The increasing price offsets the risk of the decreasing price. Pairs trading is a bit trickier than a direct hedge because you must find two assets that are nearly identical. This could mean finding two stocks with similar fair values, but one is undervalued and the other overvalued.

3. Safe haven trading is a third hedging strategy to try. For example, you might have heard of investors purchasing gold when they’re worried about currency values tumbling. Gold is considered a ‘safe haven’ asset that retains its price over time.

How to get started

To start employing any of the strategies above, you’ll need to get strategic with your trading. Begin with determining the asset class or market you’re most interested in, whether it’s Forex, derivatives, or commodities. You’ll then need to look for contrasting opportunities where a gain in one position is offset by a loss in a second.

For lower risk investments, there’s no need to use hedging strategies. Hedging is meant to offset risk. It costs money to open a new position, so you should only do so when it’s justified by an expected decline in value. If you’re unsure, alternative risk management strategies include reducing your position or simply diversifying your portfolio.

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