Investing is inherently risky: the more you expect to earn, the more you can lose. That’s why investors employ various methods of lowering their risks. These methods are called hedging techniques, and a successful trader should know at least a couple of them. That’s why we’re going to explain how those techniques work and when to use them.
How hedging works
Basically, hedging is a way of managing your investment risks by making opposite deals, diversifying your portfolio, using futures contracts, and so on. However, this term doesn’t include actual insurance, because hedging is very different from that. Risk hedging includes any manipulations to minimize the probability that the market price of some trading tool will change too much over a specific time period.
Hedging is essential for any trader, because ignoring price risks associated with your investments can lead to great financial losses. Those techniques are even more important in times of instability on the global markets, so any novice trader should learn at least the most basic things about hedging. If you trade currencies, you can always use it to stabilize your portfolio and protect it from sudden changes.
Pros and cons
All kinds of hedging techniques have several exceptional advantages. They allow you to limit the price risks associated with your assets, better understand the final profitability of your investments, increase sustainability of your portfolio, and so on. However, there are disadvantages, too. Most of the time, the majority of hedging techniques reduce your overall profits, and they do not actually eliminate the risks.
Useful strategies
Most of the hedging techniques allow you to manage the structure of your portfolio and protect assets by making additional deals. Let’s take a close look at some of them, this way you’ll be able to choose the best hedging strategy that works just for you.
Hedging with forward contracts is one of the most popular techniques. That means one party takes an obligation to supply some currency by a certain time, and the rate is also fixed. The other party must accept the currency and pay the predetermined amount of other currency for it. This way you can fix the price and protect yourself from any changes on the market.
Two other methods that are quite popular are futures contracts and options. They work much like the forward method but have certain differences. For example, futures allow you to avoid actual delivery of cash: you just receive (or lose) the difference between the current and the predetermined prices.
