There is no such thing as “free lunch” in investing. There is always an equivalent risk in every investment. This risk can never be totally eliminated; however, we can integrate some hedging techniques and strategies to at least lower them in order to raise our chances of securing a profitable investment.
What is a hedge?
A hedge is an investment position intended to reduce the risk of potential losses of an investment. Hedging is often thought as an advanced investing strategy, but practicing it is a very effective way of lowering the impact of losses in a portfolio.
We can think of hedging as similar to an insurance policy. When people buy a car, they usually open an insurance plan along with it. This doesn’t prevent any bad event to happen to the car, but it reduces the possible impacts if it occurs. This safe plan doesn’t come without a cost. The car owner pays monthly for the insurance plan, even if the presumed bad event does not come. Despite that, people still choose to have a backup plan than going through a big loss when something bad happens and they’re unprepared.
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How do you hedge?
Let us consider this scenario: You bought 100 shares of an automobile company which we will call company ABC. An automobile company performs well as long as the economy is flourishing. But we cannot be assured that it would perform just as well if the economy goes through a recession.
Hedging through diversification
In order to hedge from this potential risk, you can opt to buy defensive stocks. These stocks are composed of any products that are considered as basic necessities. During economic recessions, these stocks tend to gain or at least maintain their value. Thus, if you buy another 100 shares of company XYZ, which sells canned goods, then these stocks might gain in value even when your stocks with company ABC lose.
Hedging through derivatives
Another way to hedge is by purchasing put options for your shares. For example, your stocks with company ABC are currently worth $20. You are afraid that there is an incoming recession and you want to secure your profits, so you bought a put option to sell your stocks at $20 each no matter what happens in the future. This put option is a contract that gives you the right, but not the obligation, to sell a security at a specified amount within a fixed period of time. Thus, if your stocks suddenly dropped to $15 each, you can still secure your profits from the put option you purchased by giving you the right to sell your stocks at $20 each.
Importance of hedging
Hedging is a very important technique to protect your investments from unforeseen negative events. It is all about decreasing the impact of losses in order to help protect your portfolio from uncertainty. Although it comes with an additional cost, it is still worth the benefits it can give if it could secure you from a rather greater cost.
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