What is Hedging?
Hedging involves a set of financial strategies that investors should understand and utilize due to the benefits it offers. As an investment method, hedging protects an individual’s assets from exposure to a risky position that could result in a loss of value. However, hedging does not necessarily mean that investments will not lose value at all. Instead, in case of a loss, it is offset by gains in another investment.
Hedging involves recognizing the risks associated with any investment and choosing protections against any adverse events that could impact one’s finances. A clear example of this is taking out car insurance. In the event of an accident, the insurance policy will cover at least part of the repair costs.
How Do Hedging Strategies Work?
Hedging provides a balance that supports any type of investment. A common form of hedging is using derivatives or contracts whose value is measured by an underlying asset. For example, an investor buys stock in a company hoping the price of such stock will increase. However, if the price decreases sharply, the investor faces a loss.
Such losses can be mitigated if the investor uses an option to ensure that the impact of such a negative event is balanced. There are several popular and widely used strategies for this purpose. Below are some of the most common hedging strategies that investors should consider:
1. Diversification
The saying “Don’t put all your eggs in one basket” never gets old and is indeed quite logical even in finance. Diversification involves spreading an investor’s financial resources across investments that do not move in the same direction. Simply put, it is investing in different types of assets that are not related to each other so that if one asset declines, the others may rise.
For example, a trader buys stock from a hotel, a private hospital, and a chain of shopping centers. If the tourism industry, in which the hotel operates, is affected by a negative event, the other investments will not be impacted because they are unrelated.
2. Arbitrage
The arbitrage strategy is very simple yet quite clever. This strategy involves buying a product and immediately selling it in another market at a higher price. Thus, small but consistent profits are made. This strategy is most often used in the stock market.
For example, imagine a student buys a pair of shoes for 300,000 Tomans during a sale and sells them to a classmate for 400,000 Tomans. In this case, the first student makes a profit of 100,000 Tomans while the classmate is happy to have bought a pair of 500,000 Tomans shoes for 100,000 Tomans less than the store price.
3. Averaging Down
The averaging down strategy involves buying more units of a particular product even if the product’s cost or sale price has decreased. Stock investors often use this strategy to hedge their investments. If the price of a stock they previously bought significantly drops, they purchase more shares at the lower price. Then, if the price increases to a point between their two purchase prices, the profit from the second purchase may offset the losses from the first purchase. Conclusion
Summary
Certainly, there are numerous strategies to reduce trading risks that you should be familiar with and use depending on the situation. The Forex market is a high-risk market where anyone may experience significant gains or losses. Therefore, it is crucial to always conduct your trades strategically and with powerful strategies.