Investors must have a good understanding of hedging because of its advantages, feels Peter DeCaprio. Hedging is a technique of investment that protects the investor’s investment from risky situations that can erode the value of investment or result in losses. Although there is no insurance available for protecting investments, those who trade in stocks and carry considerable risks can take to hedging for protecting their assets. However, hedging does not entirely prevent losses but minimizes them mainly because the technique of hedging allows making up for the losses with gains made from other investments.
Hedging is a way of recognizing and acknowledging the dangers accompanying every investment and making a move to create a protective ring around the investments to prevent any negative impact on finances if there is any untoward incident. Hedging is like getting car insurance so that if there is any damage to the car from an accident or vandalism, there is enough financial protection available from the insurance.
How hedging works in stock trading will become clear from this article.
Diversification is the most common example of hedging that the stock market investors use for mitigating the risks when trading in stocks. Also, Diversification in stocks means avoiding putting all eggs in one basket and instead of creating a portfolio comprising of mixed assets with various risks, explains Peter DeCaprio. When you have an assortment of assets in the portfolio, it reduces the risk of the performance of one investment from affecting the return on all other investments. However, maintaining a diversified portfolio of stocks is quite challenging because it might entail large investments, which can be detrimental for the portfolio. Investing in a few companies increases the risk. You can balance it by investing in ETFs as the funds have a large number of investments and stocks that automatically meet the goal of diversification over a single stock.
The arbitrage strategy is clever but straightforward. You buy a product and sell it immediately in another market at a higher price. Thereby making a small but steady profit. It is one of the well-known hedging strategies in the stock market. However, the hedging strategy does not always work as simply as buying stocks at a lower price. And selling it at a higher price immediately because it restricts the gains. Hedging techniques in the stock market involve the use of instruments known as derivatives.
Derivatives – put options
Suppose you own the stocks of a company XYZ. And trust that it would give good returns in the long run. But are worried about some interim losses due to the strains within the industry. To protect yourself from losses, you can buy a put option in the company. For selling the stocks at a specific price or strike price. The strategy known as married put will offset the losses. If the price tumbles with the gains made from the put option.
Although hedging is an effective strategy to protect your finances if stock prices fall. It involves investing in other stocks, and the process has some costs. Only when you are sure that the potential benefits are higher. Than the expenses would the move most appropriate at that time.