Hedging in trading – what it is, how it works plus examples of hedging strategies

Hedging in trading – what it is, how it works plus examples of hedging strategies

Hedging has been a commonly used strategy in business and investing for many years. Nowadays, the concept has gained massive popularity for various reasons, many of which will be discussed

What exactly is hedging in trading?

According to thebalance.com, a hedge represents an investment that protects your open positions by limiting potential losses. However, for those traders who do not have the proper amount of experience, hedging might prove rather problematic.

To avoid or to reduce the odds of that happening, you should learn how hedging works and how it can help you.

How does hedging work?

Hedging could be an effective strategy in times of uncertainty because it can possibly remove a significant portion of the risk involved with an investment.

Should you hedge your investments if you are a day trader? The answer depends on your risk tolerance and your willingness to use derivative forms of investing—more about them in a second.

Until then, we want to add something else: keep in mind that hedging may not entirely prevent losses. However, it can reduce the effect of negative factors, such as Black Swan events.

When can you resort to hedging?

Many investors who use hedging strategies opt for derivative forms of trading - financial contracts deriving their value from an underlying real asset, such as a stock, commodity, bond, etc. Options, swaps, forward, and futures belong to the derivatives' group.

But there is another form of derivative trading that investors consider when hedging: CFDs (Contracts for Difference). In CFD trading, traders have the option of opening both long and short-term positions, so they can use these two approaches to counter the risk of adverse price movement in the volatile markets. Simply put, they can hedge one #investment by making another and counterbalance the cumulated risk.

Hedging strategies

Diversification

Diversification means investing in a collection of assets whose prices do not move together, so you can limit your potential losses every time the markets don't go in your favor. For example, some traders like to invest in both bonds and stocks because when stock prices fall, bonds such as U.S. Treasuries or corporate bonds tend to increase in value (Investopedia.com).

The same principle can be applied to other types of assets from different groups or even assets belonging to the same category. Word of warning: before diversifying your portfolio too much, make sure you know the markets well enough so you can react promptly should the situation require it.

You should also be aware of the different connections that exist between various assets. Closely correlated assets move in the same direction (for instance, Brent Crude and WTI), while inversely correlated assets usually move in different directions (see the bonds-stock example from above).

Opening two opposite trades on the same instrument

Opening two opposite trades on the same instrument is another hedging strategy. You can apply it to currencies, stocks, indices, commodities, or other groups of assets, depending on what you prefer.

Make sure you time your trades right. A good idea could be to wait for major market events such as the NFP, banking policy decisions, or OPEC meetings. These highly sought-after events tend to generate multiple trading options for investors. Apart from that argument, they also benefit from significant market coverage, so you have better chances to find all the info you need about them.

Investing in the so-called safe havens

Some assets fall into the safe-havens group, according to market consensus. Generally, traders turn their attention to them during volatile market periods, looking to reduce their risks and hedge their investments. The Japanese Yen, the Swiss Franc, and gold are three examples of perceived safe-haven assets.

The Japanese Yen is regarded as a haven because of the large external treasuries the Bank of Japan (BOJ) holds overseas. Additionally, the JPY is the second-largest holder of U.S. treasuries after China.

The Swiss franc reflects the stability of the Swiss economy and the Swiss financial system's strength, making it a safe-haven asset to many traders. Over the years, the CHF has usually appreciated during periods of increased volatility.

Finally, gold can also be placed into the safe havens' group because it is considered a hedge against #inflation, and it also tends to preserve its value in the long-term.

Final Thoughts

Hedging could prove a viable solution for reducing trading risks. With enough study and practice, you can improve your hedging strategies and get one step closer to achieving your investment objectives!

Do you want to learn more about popular markets, trading concepts, and strategies? Then visit the CAPEX Academy, your go-to place for enriching your knowledge!

Sources: babypips.com, investopedia.com, thebalance.com

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