Hedging is one of the most popular risk management strategies. It involves taking offsetting positions to minimize the investor’s exposure to adverse price movements. Various market entities and economic players apply hedging to reduce the inherent risk associated with investing or operating in the financial markets.
In this article by Finestel, we focus on providing a basic explanation of what hedging is. Determining how hedging is different from other popular investment strategies, we then move on to describe how it works, who should apply it, and what benefits or drawbacks it brings to the table. Finally, we shift our attention towards this concept in the crypto market and provide some practical tips on how you should do it effectively.
What Is Hedging?
Hedging is a useful investment strategy that market participants and even some non-financial businesses utilize to reduce their risk exposure to price volatility and uncertainties in the economy. You can conduct hedging by taking positions in assets with negative correlation or using certain derivatives to mitigate the potential losses caused by certain events.
Hedging works like insurance for investors. Their main goal for applying this technique is to limit their portfolios’ downside risk and preserve the value of their investment. For instance, a stock market investor who anticipates interest rate hikes and, consequently, a downtrend in market prices might utilize this technique to protect his portfolio against a potential decrease in value.
Hedging vs. Diversification
While both are risk management strategies, hedging and diversification are distinct techniques with different purposes. As previously mentioned, the former concentrates on diminishing risk and protecting gains against certain economic events and adverse price movements. It usually involves taking positions in negatively correlated instruments or using derivatives. Investors can achieve perfect hedging by investing in assets with a correlation coefficient of minus one.
On the other hand, diversification is a more general technique for minimizing the risk of longer-term investments. Diversification is mostly done through investing in markets or asset classes with minimal correlation while still aiming to gain profits under different economic circumstances. A trader can create a perfectly diversified portfolio by taking positions in assets with zero correlation.
Hedging vs. Speculation
As already explained, hedging focuses on reducing risk and preserving value and is mainly a risk management strategy. Yet, speculation is an investment strategy and its main goal is to gain profits from certain price trends. Speculators bet their money on certain assets to reach a predetermined price level to reach monetary gains.
How Does It Work?
As mentioned already, one can benefit from hedging by taking positions in different directions or investing in negatively correlated assets. Here is a general overview of this process:
- Risk identification: The first step to hedge your portfolio is to determine the risks threatening your investment. These could vary between market risks, economic risks, or even natural disasters you anticipate to occur.
- Identify instruments: Depending on the nature of the risk you are aiming to hedge against, you should identify which asset class of instrument is best suited to reach your goal. You can either invest in assets that demonstrate a highly negative correlation coefficient with your current portfolio and invest in them or use derivatives like futures, options, and swaps.
- Determining proper volume: By applying specific mathematical and statistical methods, you can calculate the volume you need to invest in hedging instruments to approach a perfectly hedged portfolio.
- Monitoring and evaluation: You should actively monitor and manage your portfolio based on real-time market conditions and asset performances to maintain a highly hedged portfolio balance with suitable relative asset allocation.
While the steps above seem simple, hedging in forex, stocks, and crypto can be very challenging. You require financial and investment expertise to hedge your portfolio optimally, or you can delegate these tasks to an asset manager or a financial consultant.
Who Should Hedge?
While financial entities mostly do hedging, many other entities also utilize this strategy:
- Investors: By investors, we usually mean individuals with long-term investments in the financial markets. These investors generally look for either capital gains or dividends (stock market investors). By hedging their portfolios, investors achieve protection against losses in capital due to bearish market conditions.
- Speculators: Traders or speculators are a group of market participants who bet on certain price movements to gain profits. When a trader has an open position, he might identify a potential risk that could cause the market to move in the opposite direction. Therefore, by utilizing specific derivatives or taking positions in other asset classes with negative correlations, they can protect their profits or avoid significant losses.
- Asset managers: Asset managers are investment specialists who manage other people’s funds in the financial markets. They can either be individuals, teams, or firms like hedge funds. While an asset manager’s main purpose is to gain profits for their investors, they are also responsible for protecting their capital against potential drawdowns. So, they need to use hedging strategies to achieve this goal.
- Financial institutions: Institutions like banks, large funds, and insurance companies that operate mainly in the financial markets need to manage their risk. Hedging in finance is mainly done by these financial institutions that generally have considerable exposure to the markets, and by hedging, they ensure they can continue their operations.
- Non-financial businesses: While financial institutions are mostly affected by price movements, other non-financial businesses like airlines are also exposed. They can apply hedging strategies by themselves or 3rd party financial institutions to protect themselves against financial or non-financial disasters.
When Should a Trader Hedge?
There are several different occasions when traders should consider hedging their positions. Adverse market conditions and high volatility are the first conditions. Based on fundamental or technical analysis, traders might conclude that the market is about to move unfavorably. In this case, the trader must hedge his open positions when the price is moving in the opposite direction to prevent losses or erosion of his unrealized profits.
Another example where you might need to hedge is when you expect certain economic, geopolitical, or natural events to occur. These events usually introduce risk factors that endanger investment portfolios or speculative positions. So, traders should apply relevant hedging strategies to mitigate the resulting risk and subsequent drawdown.
Pros and Cons of Hedging: Evaluating the Benefits and Drawbacks
Hedging involves various benefits and drawbacks. Sound risk management is crucial when operating in the financial market, and hedging is one of the most effective risk management methods. Yet, it can also lead to a few disadvantages, especially if not done properly. We present a few pros and cons of hedging below:
- Risk mitigation: The main purpose of hedging is to diminish the threats endangering your portfolio. You can protect your funds and preserve your profits by engaging in certain hedging practices.
- Flexibility: It can provide flexibility under various market conditions. Working as a portfolio insurance, hedging enables you to weather various economic environments.
- Limiting gains: While traders can create a floor for their downside risk, they also create a ceiling for their potential gains simultaneously. By applying these strategies, you will not be able to reach the maximum potential profits, as negatively correlated assets can erode their respective gains.
- Complexity: It can be a challenging practice, especially for novice and inexperienced traders. It requires sufficient knowledge and expertise. Without these requirements, you are likely to mess up your asset allocations and suffer huge losses instead of preventing them.
- Costs: There are always various monetary and opportunity costs associated with hedging. Investing in different assets and utilizing derivates requires paying commissions and fees to financial intermediaries. Moreover, there are always better investments you can make. Therefore, by hedging, you incur opportunity costs.
Types of Hedging Risk Strategies for Risk Management
There are several different strategies you can apply to hedge your investment. Here are a few examples:
- Offsetting positions: You can invest in different assets that demonstrate negative correlations. With proper allocation, you can offset the downside risk of one asset class with potential gains in another.
- Using futures contracts: Futures contracts are derivatives that involve an obligation to buy or sell a certain amount of an underlying asset at a specific price and a predetermined date, regardless of current market prices. Therefore, traders can use these contracts for hedging purposes.
- Buying Options: Options are another type of derivative instrument. As their name suggests, they provide the option for their holder to buy or sell the underlying asset at a specific price in a certain timeframe. Options are also a popular tool for hedging.
There are other derivatives and strategies used for hedging. But, we chose to stick with the most basic and accessible ones. Each of these tools can also involve different sub-strategies, and the trader should apply the suitable one considering market conditions and personal preferences. Explaining these sub-strategies requires a significant amount of prerequisite financial knowledge for the reader to grasp them fully and would not fit the main purpose of this article.
What is Fully Hedged?
A fully hedged portfolio is one that is perfectly protected against potential risks. In this situation, the effects of any adverse price movement, economic event, and uncertainties are completely offset. However, note that a fully hedged portfolio is likely to have very limited or even no potential gains.
For instance, investors can create a fully hedge portfolio by investing in other assets with negative correlations with stocks. Options and futures contracts can also be used to fully mitigate the risk of a downtrend in the stock market. Yet, to construct such a portfolio, one should apply complex mathematical and statistical methods to determine optimal asset allocations and achieve perfect hedging.
How Does Hedging Work in Crypto?
There are a few different ways to hedge your crypto portfolios in this high-risk financial market. The most common way to hedge your holdings is using perpetual futures contracts, available for trading in crypto exchanges. For example, you can short the cryptos you hold in derivatives exchanges to partially or even completely hedge your portfolio in bearish market conditions.
Furthermore, there are other strategies you can apply. Buying put options, which give you the right to sell a certain amount of the underlying crypto at a predetermined price in a specific timeframe, is one method. In this case, you can buy puts at your entry price. You will then be able to offload your coins without suffering any losses in case the coin undergoes a decline in value.
Holding stablecoins also enables you to hedge your capital in bear markets. Stablecoins are cryptocurrencies that their prices are fixed to a certain asset or currency’s value. Most stablecoins are based on the U.S. dollar, with each coin traded at $1, and holding them is almost equivalent to holding cash. However, note that these stablecoins have inherent risks associated with them, like insolvency and credit risks threatening their issuing companies. Decentralized stablecoins are also susceptible to technical risks. Therefore, keep in mind to diversify your stablecoin holdings to mitigate these risks.
Tips for Hedging in Crypto
In this section, we present a few valuable tips in crypto:
- Understand the crypto market: Try to constantly educate yourself about the nature of the crypto market and the risks associated with investing in it.
- Understand hedging instruments: To hedge your portfolio efficiently, you should learn how instruments like perpetual futures contracts work and how to utilize them.
- Use reputable exchanges: To access hedging instruments, you need to use crypto exchanges. Always use reliable exchanges with high trading volume to prevent technical issues like order execution problems.
- Actively monitor the market: The crypto market is constantly evolving at an outstanding pace. Make sure to stay informed on economic events and market trends.
- Seek advice: While you can always educate yourself and learn different hedging strategies, it is also beneficial to seek professional advice from experts to facilitate your learning process and protect yourself against the risk of ruin.
Is Hedging 100% Risk-Free?
As hedging is a risk management strategy, there is a misconception about it being risk-free. There are various risks involved in this process. The main risk associated with hedging would be mistakes and miscalculations in market analysis or asset allocation. These issues can result in detrimental financial outcomes.
Moreover, there are other risk factors, such as counterparty risks concerning the other parties you need to engage with. For example, credit and liquidity risks are a couple of prominent risks in dealing with derivatives exchanges. Opportunity costs are also included in hedging practices, as you are likely to miss out on significant profits trying to preserve your capital.
Hedging in a Nutshell: An Infographic
In this article, we introduced hedging as one of the most common and effective risk management strategies for operating in the financial markets. By comparing it to other risk management methods and explaining how it works and when to apply it, we constructed a deeper understanding of this concept. Also, while mentioning the benefits associated with hedging, we also stated that it’s not risk-free, demonstrating the potential drawbacks.
Minimizing risk and drawdown is the main benefit of hedging your investment. It can also provide flexibility to operate in different circumstances and market conditions. Yet, costs and complexities, counterparty risks, and opportunity costs in terms of reduced gains are also involved in this process. So, traders and investors must significantly educate themselves before trying to hedge their portfolios, or they would otherwise suffer heavy losses in the process.
What is hedging, in simple words?
Hedging, in simple words, is a strategy used to mitigate the risks of investing in financial markets or even operating in an economy as a whole.
What is hedging with an example?
A simple example of hedging is when you hold Bitcoin but expect the market to decline. In this case, you can short BTC using perpetual futures contracts with an appropriate volume to hedge your portfolio against the risk.
How can I determine the right hedging strategy for my needs?
To determine a suitable strategy, you need to consider market conditions, available instruments, the costs of using them, risk tolerance, and personal preferences.
What are some common hedging strategies?
Some common hedging strategies are using derivative instruments like options and futures contracts or investing in assets with negative correlation.
Is diversification the same as hedging?
No. Diversification is a general risk management strategy usually used for protecting long-term investments. On the other hand, It is mostly used to mitigate the risk associated with a certain event or adverse price movement.