Risk-free strategy: Incorporating hedging into your trading practice

Trading and investing are activities that always involve a certain level of risk, regardless of the style of trading or investing used. However, there are strategies available to mitigate these risks and protect your portfolio from market movements that could affect your assets. Hedging is a popular trading technique to hedge against unfavourable price movements and is used by many active traders and investors.

What is hedging in trading?

The main purpose of hedging techniques is to reduce the risk of loss by optimising your money management strategy. It is also possible to use hedging to make profits by taking advantage of corrective price movements, but this is not its primary purpose. In general, hedging is used to open a position opposite to an existing position that you want to protect against unfavourable movements. Any losses on one position can be offset by gains on a position taken in the opposite direction. There are other hedging methods and various financial products that you can use to gain the benefits of hedging in the stock market.

What are the most popular methods of hedging?

The first method of using hedging is to open a position that offsets another existing position. This involves opening a position in the same asset but in the opposite direction. In this case, there are several options, such as short selling using derivatives such as options or futures. Your choice will depend on your risk appetite, knowledge of the markets, objectives and market conditions.

It is not uncommon for traders to use equity derivatives in the short term to offset their long equity positions. In this way, they can protect them from downward movements and even make short-term profits if the short positions are closed and the stock price rises strongly afterwards and continues to rise for a long time. You can also use options to offset a drop in the stock price by selling a call option.

You can use hedging to protect yourself from the effects of currency fluctuations when you invest in international companies whose share prices are denominated in foreign currencies. Of course, the currency risk of your positions in global markets depends on the value of the shares you are trying to protect. It is therefore important to keep a close eye on the amount you wish to hedge in relation to the share price.

Benefits of hedging

Hedging in trading is a technique applicable to a variety of financial markets including currencies, stocks, indices and commodities. It can be used on any time frame and with any trading strategy. This technique helps to reduce the risk of loss on your positions, especially in times of high volatility or unfavourable market movements, which is especially important for long-term investors.

One of the key benefits of hedging is the ability to lock in or secure large profits on certain positions, such as through the use of options. This allows short-term profits to be realised, offsetting potential losses on medium- or long-term positions. In addition to market risk, hedging also helps protect against currency risk. There are many methods and financial products available for hedging, allowing you to adapt to changing market conditions. Overall, hedging allows you to manage your portfolio more efficiently and with peace of mind, reducing the overall risk of your positions.

What risks are associated with hedging?

Sometimes hedging can be used with complex financial products that require some knowledge and trading experience. If you are not fully familiar with how these products work, it is possible that your hedging positions may result in losses. Keep in mind that hedging is a technique that incurs additional costs in the stock market. Depending on the products used, the technique can either reduce your potential profits or increase your ultimate losses. Think about option premiums or margin transaction fees, for example.

Using hedging in trading is advisable in most cases, but you should be careful not to over hedge. There is a real risk of over hedging, which can expose you to additional risks. Depending on market conditions, hedging may not be appropriate, for example, when markets are moving in a broad sideways direction. Also keep in mind that hedging is an operation not allowed by all stockbrokers.

Conclusion

Hedging can be used in different ways, depending on your financial goals and market conditions. You may use hedging to reduce the risk of loss or limit price volatility on an existing position, to take advantage of trading or investment opportunities, or to manage currency risk. While hedging by no means guarantees a profit or full protection against loss and involves additional costs, it is nevertheless a relevant risk management tool to limit potential losses in accordance with your risk appetite, investment horizon and financial objectives.