Hedging explained
Hedging is defined as holding two or more positions at the same time with the intent of offsetting any losses from the first position with gains from the other.
At the very least, hedging can limit loss to a known amount. It can be likened to insurance: hedging will not prevent an incident occurring, but it can protect you if the worst should happen.
It is a risk management tool used by short to mid-term traders to protect against unfavourable market movements. Hedging is not typically used as part of a long-term strategy because short-term price fluctuations have little impact on buy-and-hold investors.
Why do traders hedge?
When traders hedge, they do so not as a means of generating profit but as a way of minimising loss. All trading involves risk because there is no way to prevent the market moving against your position, but a successful hedging strategy can minimise the amount you would lose.
For example, as the forex market is so volatile, no one can know exactly what will happen next, so hedging can be a great way to minimise your exposure to currency risk.
The advantage of using a hedge, rather than closing your position and re-entering at a better price, is that your trade remains on the market. Once the negative price movement is over, you can close your hedge.
How to hedge
Hedging is achieved by strategically placing trades so that a gain or loss in one position is offset by changes to the value of the other. This could be through opening a position that directly offsets your existing position or by choosing to trade assets that tend to move in a different direction to the other assets you are trading.
As there is a cost associated with opening a new position, you would likely only hedge when this is justified by the reduced risk. If the original position were to decline in value, then your hedge would recover some or all those losses. But if your original position remains profitable, you can cover the cost of the hedge and still have a profit to show for your efforts.
An important consideration is how much capital you have available to hedge, as placing additional trades requires additional capital. Creating a budget is vital to ensuring that you do not run out of funds. A common question is ‘how much should I hedge?’, but the answer will vary from trader to trader, depending on their available capital and attitude to risk.
The amount you should hedge depends on whether you want to completely remove your exposure, or only partially hedge a position. Hedging should always be tailored to the individual, their trading objectives and desired level of risk.
Hedging can be done through a variety of financial instruments, but derivative products that take their value from an underlying market – such as CFDs – are popular among traders and investors alike.
Two popular hedging strategies
Your choice of hedging strategy will depend on a variety of factors including the market you are trading, your risk appetite and your preference of financial instrument. Certain hedging strategies will require an understanding of more complex instruments, such as options and futures contracts, so it is important to do your research before you trade.
There are numerous hedging strategies that you can use in your trades, which vary in terms of complexity. We have outlined two of the most popular hedging strategies to help you get started:
Delta hedging
Delta hedging is a technique used in stock options trading to reduce or hedge against the risk associated with price movements in the underlying market. The delta is the ratio that compares the price of an underlying asset to the price of the derivative being used to trade it. For example, if an option has a delta of 0.5, the option will move 0.5 points for every one point of movement in the price of the asset being traded.
There are two methods of delta hedging: using another option or using derivatives to trade the underlying asset.
Example of delta hedging with options
An options position can be hedged with another options position that has an opposing delta. For example, if a put option on a stock has a delta of -0.40, it will rise by $0.40 if the share price falls by $1. This can be hedged with a call option that has a delta of +0.40, that will rise by $0.40 if the share price increases by $1. The position would then remain delta neutral.
Example of delta hedging with derivatives
If on the other hand, you wanted to create a delta hedge while trading the stock, you could open a position on the share using a derivative.
So, if you are long one call option that has a delta of 0.75 (bearing in mind that options have a multiplier of 100), you could hedge this delta exposure by shorting 75 shares of the stock via a CFD trade. This would also create a delta neutral position.
Risk reversal
Another hedging strategy is risk reversal, which aims to protect a long or short position by using put and call options. While this strategy protects the position from losses, it does restrict the position in terms of profit as well – this is why the strategy can also be known as a ‘protective collar’.
Example of risk reversal
Let’s say that you are short on 100 units of sugar, but want to hedge your exposure, you might decide to use the risk reversal technique. To do this, you would purchase both a call option and a put option, both for 100 units of sugar.
If the price of sugar rises, the call option will become more valuable and offset any losses to the short sugar position. If the price of sugar fell instead, you would profit from the short position but only to the strike price of the put option.
Alternatives to hedging
Although hedging strategies can be useful if you have a long-term belief that the market will rise or fall as you expect, they are not always beneficial.
If you are unsure about a market’s future or can’t make a decision about how to hedge, then you might want to prepare for market risk by simply reducing the size of your position, or by not opening a position at all.
Easily start hedging
The best way to learn about hedging strategies is to try them out for yourself and see which strategy works best for your personal goals. You can develop your hedging strategy in a risk-free environment by opening an IG demo trading account or, if you feel confident that you are ready to start hedging on live markets, you can open an account with IG in minutes.
