Nowadays, any business can face fluctuations in exchange rates. In order not to lose money due to an unwanted price move, it is important to protect yourself from risks. Hedging is one of the most widely-used methods of doing so.
The concept of hedging is to secure the capital against risks such as price movements, exchange rate fluctuations, changes in interest rates, and many other unpredictable factors.
When traders decide to hedge, they protect themselves against possible losses. For that reason, this capital management method is also called insurance. It is important to understand that the main essence of hedging is to minimize risks rather than to yield higher profits. Hedging means to protect your capital from uncertainty and it is sometimes achieved by means of reducing potential profits.
Risks are minimized by opening opposite positions in the same instrument in different, but economically related markets. Simply put, the hedger has the right to open two transactions in opposite directions (to buy and sell an asset) in order to compensate for losses in case one of these transactions is unsuccessful. In order to understand how this algorithm works, let us take a look at major instruments and hedging strategies related to them.
Several expiry instruments, or derivatives, can be used to implement insurance strategies. They can be of two types: over-the-counter and exchange-traded. The former are forward contracts and swaps, and the latter are futures and options. We will focus on futures and options, since they are the main hedging instruments on Forex..
A futures contract (or futures) is a special agreement between the parties for future delivery of an underlying asset:
shares;
stock indices;
currencies;
deposits;
precious metals.
In order to enter into a futures contract, the trader should deposit funds equal to a specified percentage of the nominal value of the contract. The futures in turn will guarantee the trader a right and obligation to buy or sell the asset at a certain time in the future but on terms specified at the time of the transaction. For example, the price of a futures contract on an asset is always set in advance.
There are two categories of futures market participants: hedgers and speculators. As sellers, hedgers always strive to set the highest possible price, aiming to protect themselves from its potential decline in the future. Accordingly, as buyers, hedgers act differently. They try to set the lowest possible price, hoping to secure themselves against its potential increase.
Thus, hedgers’ main goal is to ensure that the price of an asset will not change. The security algorithm works owing to the presence of speculators ready to accept all risks. Speculators can actually benefit from those price fluctuations hedgers try to protect themselves from. Speculators, on the contrary, want to take advantage of the risky nature of the futures market. After all, the higher the risk, the greater the profit.
So, how can hedgers protect themselves and even earn money on a futures contract? Supposedly, you have bought the issuer’s shares for $40. You expect the quotes to increase in the next 2 months so that you can sell the securities at a higher price. But the market is unpredictable. Therefore, you can protect yourself from a possible decline in price by selling the futures contract with the same number of securities at a market price of $50. If the price falls to $35 from $40, you can offset your losses, receiving income from the futures contract. All you need is to sell the shares and purchase the contract. Let us calculate:
$50–$35=$15 (profit on futures)
$40–$35=$5 (losses on shares)
$15–$5=$10 (final profit)
At the same time, the trader should always bear in mind that hedging with the help of a futures contract has one main flaw. Shares can spike in price. In such a case, the price of the futures contract should not exceed the initial difference between its value and the security price ($50 – $40 = $10). Let us say that the stock price has soared to $75 and you have earned $35. But if the value of the futures contract is above $85, you will incur losses and gain nothing.
An option contract is one more type of exchange-traded financial instruments used for hedging. They can be of two types:
Put option allows the holder to sell the underlying asset at a set price. When buying such a contract, a trader can set the minimum price so as to benefit from its increase in the future.
Call option allows its holder to buy the underlying asset at a set price. In this case, sellers of the option usually benefit more than buyers because they receive a reward from selling each unit of the contract.
Thus, the option, like the futures contract, grants the trader an opportunity to buy or sell the underlying asset at a certain price within a limited period of time. The only difference of the option is that it is the so-called unequal contract. This means that only one party, the seller, has obligations. Meanwhile, the buyer is given carte blanche and can either use the option or leave it in case it is unprofitable. When the price moves in the opposite direction, the buyer can use the option, adjust losses, and earn profits. Conversely, if the price moves in the right direction, the player can choose not to use the option and simply ignore the contract.
Interestingly, in such a case, the seller loses nothing because s/he gets a reward for the option, the amount of money calculated based on the current price of an asset and its features. The buyer always transfers these funds to the other party as a reward for the transaction. The seller keeps the money in any case, even if the buyer decided not to use the option.
Let us turn to another example in order to see how this algorithm works. Supposedly, you have purchased shares of the same issuer for $40. You now want to hedge them. For that reason, you have bought a put option contract allowing you to sell the shares at $50. In this case, a reward to the seller for the contract is $3. You can use the option and sell the shares at $50. Thus, your income from each security will be $7 ($50– $40– $3 = $7). If the assets rise to $75, you do not have to use the option because it is inappropriate. You can sell the shares at $75 and receive an income of $32 ($75- $40- $3 = $32).
Despite all its advantages, hedging is considered to be a rather difficult money management approach, especially for novice traders.
That is why before you adopt this strategy, it is always worth weighing all the pros and cons:
If potential losses turn out to be less than hedging costs, then it would be wiser not to follow this method.
If hedging is still an option, you should carefully analyze not only the asset you have chosen, but also the corresponding industry, and the current economic situation. This will help you select the necessary instrument (or even several instruments), as well as to choose the best strategy.
The concept of hedging is to secure the capital against risks such as price movements, exchange rate fluctuations, changes in interest rates, and many other unpredictable factors.
When traders decide to hedge, they protect themselves against possible losses. For that reason, this capital management method is also called insurance. It is important to understand that the main essence of hedging is to minimize risks rather than to yield higher profits. Hedging means to protect your capital from uncertainty and it is sometimes achieved by means of reducing potential profits.
Risks are minimized by opening opposite positions in the same instrument in different, but economically related markets. Simply put, the hedger has the right to open two transactions in opposite directions (to buy and sell an asset) in order to compensate for losses in case one of these transactions is unsuccessful. In order to understand how this algorithm works, let us take a look at major instruments and hedging strategies related to them.
Several expiry instruments, or derivatives, can be used to implement insurance strategies. They can be of two types: over-the-counter and exchange-traded. The former are forward contracts and swaps, and the latter are futures and options. We will focus on futures and options, since they are the main hedging instruments on Forex..
A futures contract (or futures) is a special agreement between the parties for future delivery of an underlying asset:
shares;
stock indices;
currencies;
deposits;
precious metals.
In order to enter into a futures contract, the trader should deposit funds equal to a specified percentage of the nominal value of the contract. The futures in turn will guarantee the trader a right and obligation to buy or sell the asset at a certain time in the future but on terms specified at the time of the transaction. For example, the price of a futures contract on an asset is always set in advance.
There are two categories of futures market participants: hedgers and speculators. As sellers, hedgers always strive to set the highest possible price, aiming to protect themselves from its potential decline in the future. Accordingly, as buyers, hedgers act differently. They try to set the lowest possible price, hoping to secure themselves against its potential increase.
Thus, hedgers’ main goal is to ensure that the price of an asset will not change. The security algorithm works owing to the presence of speculators ready to accept all risks. Speculators can actually benefit from those price fluctuations hedgers try to protect themselves from. Speculators, on the contrary, want to take advantage of the risky nature of the futures market. After all, the higher the risk, the greater the profit.
So, how can hedgers protect themselves and even earn money on a futures contract? Supposedly, you have bought the issuer’s shares for $40. You expect the quotes to increase in the next 2 months so that you can sell the securities at a higher price. But the market is unpredictable. Therefore, you can protect yourself from a possible decline in price by selling the futures contract with the same number of securities at a market price of $50. If the price falls to $35 from $40, you can offset your losses, receiving income from the futures contract. All you need is to sell the shares and purchase the contract. Let us calculate:
$50–$35=$15 (profit on futures)
$40–$35=$5 (losses on shares)
$15–$5=$10 (final profit)
At the same time, the trader should always bear in mind that hedging with the help of a futures contract has one main flaw. Shares can spike in price. In such a case, the price of the futures contract should not exceed the initial difference between its value and the security price ($50 – $40 = $10). Let us say that the stock price has soared to $75 and you have earned $35. But if the value of the futures contract is above $85, you will incur losses and gain nothing.
An option contract is one more type of exchange-traded financial instruments used for hedging. They can be of two types:
Put option allows the holder to sell the underlying asset at a set price. When buying such a contract, a trader can set the minimum price so as to benefit from its increase in the future.
Call option allows its holder to buy the underlying asset at a set price. In this case, sellers of the option usually benefit more than buyers because they receive a reward from selling each unit of the contract.
Thus, the option, like the futures contract, grants the trader an opportunity to buy or sell the underlying asset at a certain price within a limited period of time. The only difference of the option is that it is the so-called unequal contract. This means that only one party, the seller, has obligations. Meanwhile, the buyer is given carte blanche and can either use the option or leave it in case it is unprofitable. When the price moves in the opposite direction, the buyer can use the option, adjust losses, and earn profits. Conversely, if the price moves in the right direction, the player can choose not to use the option and simply ignore the contract.
Interestingly, in such a case, the seller loses nothing because s/he gets a reward for the option, the amount of money calculated based on the current price of an asset and its features. The buyer always transfers these funds to the other party as a reward for the transaction. The seller keeps the money in any case, even if the buyer decided not to use the option.
Let us turn to another example in order to see how this algorithm works. Supposedly, you have purchased shares of the same issuer for $40. You now want to hedge them. For that reason, you have bought a put option contract allowing you to sell the shares at $50. In this case, a reward to the seller for the contract is $3. You can use the option and sell the shares at $50. Thus, your income from each security will be $7 ($50– $40– $3 = $7). If the assets rise to $75, you do not have to use the option because it is inappropriate. You can sell the shares at $75 and receive an income of $32 ($75- $40- $3 = $32).
Despite all its advantages, hedging is considered to be a rather difficult money management approach, especially for novice traders.
That is why before you adopt this strategy, it is always worth weighing all the pros and cons:
If potential losses turn out to be less than hedging costs, then it would be wiser not to follow this method.
If hedging is still an option, you should carefully analyze not only the asset you have chosen, but also the corresponding industry, and the current economic situation. This will help you select the necessary instrument (or even several instruments), as well as to choose the best strategy.
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