Hedging Transaction
Candlefocus EditorPut simply, the purpose of hedging is to reduce the risk of investing. Hedging, when done correctly, can help to reduce the uncertainty associated with investments while also potentially preserving capital gains. The use of derivatives, such as options and futures, can help investors protect their investments, as they allow investors to lock in gains and cut potential losses, while still participating in market potential.
Investors who use hedging transactions typically take a long position and then buy a “hedge” against potential losses. This hedge can take the form of an option, futures contract, or other derivatives. Hedgers may also use some combination of the three, thereby diversifying their risk even further. By buying or selling derivatives when market prices move in a certain direction, investors can limit their risk and exposure against price swings in the underlying investment.
For example, if a portfolio is heavily exposed to a particular sector, such as energy, an investor could use futures to protect against risk exposure for that sector by hedging against the sector. This can be done by buying energy-specific commodities in the futures market, lowering the risk associated with energy investments and potentially helping to protect future gains. Similarly, an investor can use options to protect a portfolio when market prices become more volatile. Purchasing put options for stock can help protect any potential downside risk in the stock price.
Hedging requires knowledge of markets, as well as the tactical use of derivatives and inversely correlated instruments. Although it involves an element of risk, investors who understand the mechanics of hedging can use it to minimize their risk exposure and increase the potential for gains in their investments.