Hedging refers to making an investment to reduce the risk of adverse price movements in an asset held or expected to be held. It involves taking an offsetting position in a related security to mitigate losses from negative price fluctuations. Hedging is an essential risk management technique in trading.
Definition of Hedging
The simplest hedging example involves a wheat farmer short selling wheat futures to lock in wheat prices in advance of their harvest, offsetting risks from falling prices later. Airlines buying oil futures to offset rising fuel costs is another analogue. Implementing futures contracts with opposing exposures allows neutralizing risks.
Objectives of Hedging
The core goals of hedging strategies are to:
- Protect existing investments and expected transactions from declining in value
- Reduce volatility and provide downside loss protection
- Limit risks faced when holding positions or executing planned trades
- Enhance risk-adjusted returns through reduced drawdown impacts
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Popular Instruments for Hedging
Common securities used for implementing hedges include:
- Futures contracts in commodities, bonds and currencies
- Options contracts granting downside protection
- Inverse exchange-traded funds (ETFs) tracking major indexes
- Credit default swaps protecting against bond defaults
- Foreign exchange forwards locking currency rates
Challenges Associated With Hedging
While hedging mitigates risks, there are some challenges:
- Potential for overhedging beyond tolerances
- Higher transaction costs from implementing hedges
- Mismatched timing between hedge positions and exposures
- Difficulty unwinding hedges during volatile markets
- Opportunity cost relative to holding the underlying only
In summary, applied strategically, hedging allows traders to realize some of the upside potential while minimizing downside risks. Mastering hedging fulfills the key trading mandate to preserve capital and manage losses.
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