HEDGING 101: THE BASICS
Hedging is one of the commonly heard terminologies in the field of investing and is considered as important as portfolio appreciation. Every individual with the intention of heading towards the financial realm must understand not only its concept, but also how it works as this will be handy especially for for safeguarding your holdings.
Hedging is best likened to insurance, as it offers protection to offset your losses in case of an unwanted event. For example, house guarantees trim down the expenses you would have to compensate for the damages in case of a fire. When it comes to investments, this process is done to reduce the impact of frequent price fluctuations on your assets. However, it has more complex procedures than merely providing an annual payment. It utilizes specific instruments commonly known as derivatives and basically requires additional investment to guard the others, wherein you will benefit from in case it loses money. Of course, this is not a perfect method as a reduction in risk will also mean lesser profitability, and vice versa. This is because hedging is practiced not for the purpose of gaining, but to trim down potential losses.
How to do it?
Two of the most common derivatives to make use of is options and futures, wherein trading methods can be developed from. To get started, you are required to invest in two securities bearing negative correlations. For example, you chose to invest in a tequila company, which, despite its decent performance, is a little worrying due to short-term declines in the industry. To keep safe from a sudden slump, you can purchase an option put on the firm and gain a right to sell their products at a certain price range, which is a strategy called marriage put. If the stock slips below the established cost, you just saved yourself from a huge loss because they were offset by gains in the option.
Another style involves commodity, in case several of a particular business' products rely on it. If the costs of these commodities are to continuously hike, it would impact profit margins largely. A hedge would enable you to set a fixed price of a certain item to make you immune to future value variations. This will also enable you to create your budget ahead.
Of course, this process also entails payment, so it is necessary to ensure your expenses are justified by the benefits you receive. Unlike a guarantee, you will not be fully compensated for your misfortune and situations such as getting in the wrong the contract are inevitable.
So regardless of whether you have plans to hedge your portfolio, it is crucial to familiarize yourself with it in order to completely comprehend the market, and how companies secure themselves.