How To Hedge: Hedging Strategies

There are several distinct ways and investment hedging methods for investors. It is of great use to learn certain methods and strategies in order to achieve a perfect hedge - reduce all the underlying risks, except for the premium costs.

Hedging with Derivatives

The most widespread way of hedging against risk is realized through derivatives (options and futures). Their value derives from underlying assets like stocks, loans and commodities. Hedging with derivatives is rather reliable, since, in most cases investors are guaranteed a certain price for their security.

  • Options
Hedging Strategies Option is referred as a popular hedge. It provides not only high leverage for investing, but is also referred to as a useful tool of hedging an investment. Options are considered less risky derivatives, as long as one merely buys options.

This is a derivative that gives a right to make a stock purchase or sale at a certain price and at a specific period of time. For instance, one buys a stock, expecting further increase in its value and meanwhile tries to protect it against the risks. Here investor’s first step will be hedging the risk by means of putting an option (the right to sell). He will buy the right for a low fee. This way, one can protect their investment and get most of the amount back (minus the fee).

Determining the position

In case you have opened a long position and want to reduce the downside risk, you need to buy put options. Conversely, if you have opened a short position, you need to buy call options.

  • Futures Contracts

Future contracts are considered riskier than options. Futures provide high leverage and are mainly intended to be used by professional investors who are ready to face up the risk involved. In case of options it is quite optional to decide whether to exercise the option or not. However, the situation is quite different with future contracts; here the investor is obliged to fulfill the contract at the specified expiration date.

Determining the position

In case you have opened a long position and desire to reduce the risks, you need short contracts. Accordingly, if you have opened short positions and want to reduce the upside risk, you need long contracts.

Hedging with "Pair Trade"

This method is generally called a "pair trade" since it suggests taking an opposite position in a diverse security to reduce the risk. If you have opened a long position and want to reduce the downside risk, you should open short position with another stock. Henceforth, in case you have opened a short position and want to reduce the upside risk, you need to open a long position with another stock.