We often hear of risk cover and associate the same with insurance. However, managing market-linked financial instruments also necessitates protecting them against possible global crises that leave the world’s stock markets in a tizzy. Referred to as “hedging” in regular financial parlance, investors must park their money in different investment options with different correlations to avert the risks due to unforeseen events including the most recent Russia-Ukraine war or the worldwide pandemic that left more than a million dead in 2020.
As opposed to the myth that hedging prevents losses, the fact is that it only minimizes the extent of negative impact. Most investors employ hedging in investments including shares, equities, indices, and so on. And there are those whose investments yield earnings in foreign currencies that are subject to volatility and currency risk.
Adopting multiple hedging strategies
You may adopt a single hedging strategy or a combination of many depending on your understanding of the market and the quantum of risk you wish to avert. For example,
- Forward contract: If you are not sure of which way the market would move in a particular time frame, the best way out is to relieve yourself of stress stemming from price fluctuations by initiating a contract. This contract is made between two parties wherein they agree to buy or sell commodity stocks on a specified date at predetermined prices.
- Futures contract: This is a standard contract between two parties for selling currencies at an agreed price and quantities on a specific date. This covers myriad contracts like currency futures contracts, etc.
- Money markets: The current volatility in the equity markets has led many investors to short their investments. This hedging strategy is apt for investors and traders involved in short-term buying, lending, and borrowing of investments with a maturity date of less than a year. These contracts include many contracts including covered calls on equities, money market operations for interest, and currencies.
Common hedging methods
Hedging is a must considering the precarious nature of the market and the sudden losses that follow with the prices of some stocks sinking below 30 per cent from their 52-week highs.
One effective way can be is to plan asset allocation in a way that allows scope for diversification. Instead of filling the portfolio with only one kind of asset, you must be willing to diversify it with various asset classes. For example, you may invest only 40 per cent of your capital in equities, while the rest can be used to buy stable asset classes like debt instruments, gold, and others. This helps in the rebalancing of the portfolio.
A differently structured portfolio can work wonders to protect your capital. This you can do by using a certain amount of your money in debt instruments while the rest can be offloaded in derivatives. Since the value of derivatives is based on an underlying financial asset like equities or indices, it keeps your portfolio from sudden risks.
Exercising call and put options is another efficient way to stay in the market without exposing yourself to sudden pitfalls. For example, you use the call option when you are bullish on a particular stock and so decide to buy it at a particular price within a specified period. However, if you are wary of sudden market pitfalls, you can buy the put option to earn profits from a particular stock before its decline. You buy a put option when you are apprehensive of a possible fall in the stock price before the option expires.
Why should you hedge your assets?
This is as good as asking why you must keep the doors of your house locked. The desire for protection extends to investments too and that is why you must hedge your investments by re-allocating your assets regularly or investing according to their risk-taking ability.
Hedging techniques offer respite to both traders and investors as they help shield against market risk and volatility. Apart from reducing the risk of suffering from unwanted losses, an effective hedging technique repositions your portfolio as a safe haven that you can rely upon and fall back on during market distress.