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A Beginner's Guide to Hedging Research Team | Posted On Wednesday, April 15,2009, 12:12 PM

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A Beginner's Guide to Hedging



Although it sounds like it might be the sideline of your neighbor obsessed with his topiary garden full of tall bushes shaped like giraffes and dinosaurs, hedging is put into practice and every investor should know about - there is should be no conflict that portfolio protection is often just as significant as portfolio appreciation. Similar to your neighbor's obsession, though, hedging is talked about more than it is explained, making it seem as nevertheless, it belongs only to the most puzzling financial realms. Yet if you are a beginner, you can learn what hedging is, how it works and what hedging techniques investors and companies use to safeguard themselves.

What is Hedging?

The optimum way to understand hedging is to consider of it as insurance. When people make a decision to hedge, they are not anything but insuring themselves against a negative event. This does not avoid a negative event from happening, but if it does happen and you are properly hedged, the bang of the event is reduced. As a result, hedging occurs almost everywhere, and we see it in day to day activities. For illustration, if you buy house insurance, you are hedging yourself against fires, break-ins or other unforeseen disasters.

Portfolio managers, individual investors and corporations use hedging techniques to decrease their disclosure to a variety of risks. Although in financial markets, hedging becomes more complicated than merely paying an insurance company a fee every year. Hedging against investment risk means systematically, using financial instruments in the market. This is to offset the risk of any kind of adverse price movements. To say into other words, investors try to hedge one investment by making another.

Precisely, to hedge you would invest in two types of securities with negative correlations. Undoubtedly yes, nothing in this world is free of charge, so you still have to pay for this type of insurance in one form or another.

Although some of us may imagine about a world where profit potentials are limitless but also risk-free, hedging cannot help out us to escape from the hard reality of the risk-return tradeoff. A reduction in risk will at all times mean a reduction in potential profits. Subsequently, hedging, for the most part, is a performance not by which you will make money but by which you can reduce potential loss. If the speculation you are hedging against makes money, you will have characteristically reduced the profit that you could have made, and if the investment loses money, your hedge, if successful, will reduce that loss.

How do investors Hedge?

Hedging techniques by and large involve the use of complicated financial instruments known as derivatives and the two most common types of which are “options” and “futures”. We're not going to get into the fundamentals of describing how these instruments work, but for now just keep in mind that with these instruments you can develop trading strategies where a loss in one investment is offset by a gain in a derivative.

For an instance, say you own shares of Cory's Tequila Corporation (Ticker: CTC). Even though you believe in this company for the long run, you are a quite worried about some short-term losses in the Tequila industry. To protect yourself from a drop in CTC, you can buy a put option (a derivative) on the company, which gives you the right to sell CTC at a specific price (strike price). This approach is known as a married put. If your stock price drops drastically below the strike price, these losses will be offset by gains in the put option.

The other characteristic hedging instance involves a company that depends on a definite commodity. For an instance, Cory's Tequila Corporation is bothered about the instability in the price of agave, the plant used to make tequila. The company would be in profound trouble if the price of agave were to too expensive, which would eat into profit margins severely. To protect (hedge) against the uncertainty of agave prices, CTC can enter into a futures contract (or its less synchronized cousin, the forward contract), which allows the company to buy the agave at a specific price at a pre set date in the future. Now CTC can budget without upsetting about the fluctuating commodity.

If the agave rises above that price specified by the futures contract, the hedge will have paid off since CTC will save money by paying the lower price. Yet, if the price goes down, CTC is still obligated to pay the price in the contract and actually would have been recovered off not hedging.

Keep in mind that for the reason that there are so many different types of options and futures contracts an investor can hedge against nearly anything, whether a stock, commodity price, interest rate and currency - investors can even hedge against the weather conditions.

The Downside

Every hedge has a cost, so before you make a decision to use hedging, you must ask yourself if the benefits received from it justify the expense. Consider the goal of hedging isn't to make money or profits but to protect from losses. The cost of the hedge - whether it is the cost of an option or lost profits from being on the mistaken side of a futures contract - cannot be avoided. This is the price you have to pay to stay away from uncertainty.

We've been comparing hedging versus insurance, but we should give emphasis to that insurance is far more accurate than hedging. With insurance, you are entirely compensated for your loss (usually minus a deductible). Hedging a portfolio isn't an ideal science and things can go wrong. Even though risk managers are always try to aim for the perfect hedge, it is really very difficult to achieve in practice.

What Hedging means to you?

The majority of investors will by no means trade a derivative contract in their life. In reality most buy-and-hold investors ignore short-term fluctuation on the whole. For these investors there is little point in attractive in hedging because they let their investments grow with the on the whole market.

So why learn about Hedging?

Even if you by no means hedge for your own portfolio you should understand how it works since many big companies and investment funds will hedge in various form. Oil companies, for instance, might hedge against the price of oil while an international mutual fund may hedge against fluctuations in foreign exchange rates. An understanding of hedging will help you to comprehend and analyze these kinds of investments.

Risk is an essential so far precarious element of investing. Despite what kind of investor one aims to be, having a basic knowledge of hedging strategy will lead to better awareness of how investors and companies work to protect them. Whether or not you make your mind up to start practicing the complicated uses of derivatives, learning about how hedging works will help advance your understanding the market, which will always help you be a better investor.

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