As a result of the decline in the market, the value of our portfolio dropped by $25,000.
Calculation: 500,000 x (-5%) = -$25,000 (loss).
Types of hedging strategies
Updated: February 08, 2024
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Investing is inevitably associated with the risks of financial losses. The higher the expected return, the more dangerous the transaction. In order to protect future profits and/or prevent loss of capital, companies, financial institutions, institutional and Conclusionprivate traders use risk hedging techniques. In this article we will review what hedging is, the types and techniques of hedging, examples, pros and cons.
Currency hedging has gained particular importance in risk management against instability in the global and domestic markets. If you want to grow your capital rather than lose investment, learn what hedging is in simple words and how to use it.
What is hedging?
First, hedging is a method of insurance of transactions in the financial risks that consists of taking opposite or offsetting positions with current or futures contracts, diversification, opening of two positions in an asset with a positive correlation, as well as many other manipulations. Notably, hedging and insurance are not synonyms; they differ in content, form and consequences. Risk hedging techniques are a general term used to describe actions to minimize price risks associated with the probability that the market price of an instrument will change over a specified period of time.
The main group of risks to be hedged at the exchange market is included in the category of financial risks. These are the risks that can be optimized through the use of investment instruments. At the same time, market risks, which are often referred to as “price risks”, are the ones subject to minimization in exchange trading. They are associated with the price volatility of various commodity and financial assets. Find out about the best Forex brokers for hedging in the TU article.
A few key points to remember:
1
Hedging currency risks can primarily be applied to the situations related to adverse price changes;
2
The main purpose of hedging is targeted actions to manage price risks;
3
The peculiarity of hedging is that even such a mechanism is not perfect and cannot guarantee 100% insurance of a trader’s positions in all cases. Only risk hedging tools and methods can provide control, management and optimization of capital in the long term.
In simple words, hedging is one of the main techniques of managing mostly price risks that is often speculative in nature. Market or price risks will never be of interest for insurance companies. Hedging is possible only when specific types of transactions (spot in nature) are used at the exchanges. Exchange trading allows you to reduce or control risks by transferring them from one market participant onto another. Hedging currency risks is understood as operations of insuring transactions through trading futures or other contracts.
Why should you hedge risks?
Risk management is an integral part of financial management, ignoring which could lead to bankruptcy. In the context of global challenges and instability that has engulfed global markets, the conditions and causes of financial risks, their forecasting and prediction are of great importance. Currency hedging can solve the problem; no trading strategy is possible without it. There is a reason why hedging, which involves functioning of financial derivatives circulating in the spot market, is the most popular approach to managing market risks in international financial operations.
Naturally, hedging instruments provide significant advantages:
Limit the price risks;
Increase predictability of transaction profitability;
Level the uncertainty factor in the capital management system on the time horizon;
Increase portfolio stability and sustainability;
The strategy becomes more flexible through the expansion of the range of traded instruments and approaches to their management.
As a reminder, hedging techniques (English “hedge” — protect against possible losses, screen, shield, buffer) mean activity aimed at protection against possible future financial losses related to the change of market price of financial instruments or commodities. Currency hedging is one of the ways to stabilize an investment portfolio/business. A financial instrument means any contract with clearly defined economic consequences, the subject of which is cash (as an option – a valid right to receive funds or their equivalents). These can be futures, options, receivables, promissory notes, stocks, bonds, factoring, forfaiting, etc.
Drawbacks of hedging
Depending on the economic content and nature of a transaction, hedging techniques also have their drawbacks:
Reduction of profit potential;
Equity is the source of coverage for unexpected damage, because hedging is not identical to the notion of insurance;
High sensitivity in conditions of the unstable financial market of countries with transformation economies.
One way or another, hedging techniques are necessary if you want to expect to profit from trading activities from a strategic perspective. The profits of speculators, in their economic sense, are rightfully considered as a reward for the risk taken, and without the knowledge of hedging basics and techniques, this is impossible.
Top 8 Best Hedging Strategies
Hedging strategies are ways to influence the structure of financial assets and liabilities to limit the risk level and create a system of protection of equity through entering into additional financial agreements. In turn, hedging instruments are term monetary agreements, the mechanism of which allows minimizing the risk of an unexpected decrease in the price of investment instruments in the future.
Below, we will review the basic hedging strategies used in modern trading practice.
1. Structural balancing
This is an exclusively institutional hedging strategy used by large market players, such as banks, funds and other financial structures. According to this strategy, an organization fixes the spread and neutralizes the risk of changes in the interest rate.
The benefits of this strategy are simplicity and accessibility. However, it requires a restructuring of the balance sheet, considerable time and preparatory activities involving the analytical department of several hedgers.
2. Managing the Gap between Sensitive Assets and Liabilities (Gap Management)
This hedging strategy involves determining sensitive and insensitive to changes in the interest rates of assets and liabilities of a bank (balance sheet and off-balance sheet) to assess the interest rate on short-term intervals. It is used to monitor the state of liquidity and manage the ratios of volumes of various types of assets and liabilities.
Pros: accuracy of risk assessment, an opportunity to earn additional income.
Cons: does not guarantee full protection against the risk, difficulty of predicting the economic situation.
Gap analysis is considered a classical method of determining a bank/company’s exposure to interest rate risk. The basic idea is to analytically distribute assets and liabilities that are sensitive to changes in interest rates over time ranges. For each period, the gap is defined as the difference between assets and liabilities with corresponding maturities.
An important advantage of gap analysis as a hedging strategy is its simplicity and clarity in combination with a possibility of comprehensive analysis of assets and liabilities. It is mostly used to assess the influence of the changes in the interest rates on the financial performance and is an integral part of annual and quarterly reports of companies. Gap analysis that does not involve determining the interest rate dynamics serves only as a part of forecasting the influence of interest rate risk on the bank’s financial performance. Due to its complexity, it is more suitable for advanced traders than for beginners.
3. Hedging with forward contracts
This hedging strategy consists in one party undertaking to supply a specific quantity of foreign exchange funds at a predetermined and agreed in the contract rate on a specific date. The other party undertakes to accept the supply and pay the corresponding amount in specific currency in the future. This strategy is used at the interbank exchange and is used to provide reliable insurance of future payments or receipts under foreign trade contracts.
Pros: accuracy, no additional payments.
Cons — high risk of supply disruption, impossibility of changing the terms or resale of the contract.
In the spot market, speculators undertake the hedger risk, i.e. the risk of the price change of the underlying asset during the forward period. They are hoping that their expectations will turn out to be true and that will earn them profit. Of course, forecasts are not always correct, which is why speculators can win, but they can also lose, which is not such a rare case in reality. Buying or selling a commodity in the spot market to be delivered on specific dates is the most common form of such trading.
4. Hedging with futures contracts
When discussing this hedging strategy, one needs to understand that a currency futures is an exchange contract on the supply of a standard amount of currency at a predetermined time in the future at the predetermined price. Hedging with futures contracts allows for fixing the price as of this moment, at which the purchase or sale of the underlying assets will take place in the future.
Pros: availability, high liquidity, real supply of assets is optional.
Cons: discrepancy between the conditions of contracts and needs of a client as regards to terms and amounts, a decrease in the profitability of funds, additional payments (commissions).
Futures are specially designed tools to improve marketing and logistics or avoid price risks, in other words, hedging. Futures contracts have reduced currency risks to practically a minimum. This hedging strategy is the most common and, therefore, effective.
NOTE! A futures contract is a contract to buy or sell a commodity (asset) to be delivered in the future at a price set during the initiation of the contract. This contract obliges each party to perform its obligations at a predetermined price or by delivering goods of the predetermined quantity and quality. Since futures contracts are standardized, sellers and buyers can exchange one contract for another and actually compensate for the obligations on delivery of cash. Futures markets are the only effective mechanism for setting prices, and a viable hedging strategy in 2023.
5. Hedging with currency options
Currency options can also be found among popular hedging strategies. It is a contract that grants the buyer the right, but not an obligation, to buy or sell a predetermined amount of currency to insure an option position and protect his investment portfolio.
Pros: convenience, high profit potential.
Cons: high cost.
Exchange options are actively traded at futures exchanges and are an integral part of many hedging strategies. Unlike basic futures contracts they are based on, options are the ‘rights’ to buy or sell futures contracts at predetermined prices. Options have an expiry date that corresponds to the main futures contracts, and as a rule (but not necessarily) expire simultaneously with them. Buyers of an option buy the right to request or deliver the underlying future asset at a predetermined price within a set period of time.
Options can be a multi-faceted hedging tool that can generate profit, if used correctly. An exchange-traded option can minimize the risk, providing potential rewards to risk managers in the market.
6. Hedging with swap contracts
A swap contract is a contract between two parties on exchanging the cash flows or other assets. Swaps are calculated based on the price (quote) of the underlying asset within the amount determined by the contract as of the specific payment date during the term of the contract.
Pros: low cost, simplicity, availability.
Cons: low liquidity, risk of supply disruption.
A swap, as a rule, does not transfer the right or obligation for physical delivery. Swaps have a number of advantages over futures contracts. The only constraint that a swap creates is the desire of the other party to take on the risk that is being bought or sold. It can also be used to hedge risks that are currently not covered by exchange or cash instruments. The main value of swaps is the ability to hedge previously unprotected risks. Swaps can use indices.
7. Trading safe-haven assets
This includes hedging strategies based on the following instruments:
1
Gold. This is one of the most quoted precious metals that is considered a ‘safe haven’ for private and institutional investors due to its rarity, stability of price and reliability in the commodity market. The value of gold only increases over time, so this asset is always ideal as a risk hedging tool;
2
Debt securities (treasury and government bonds). These are considered a reliable equity ‘safe haven’ at least for a term of one year that guarantee a fixed rate of return until their maturity;
3
Currency pairs. Such monetary units as the US dollar (USD), Swiss franc (CHF) and Japanese yen (JPY) are ‘safe-haven’ currencies in the Forex market. This is because the economies of the countries that issue them are strong; their interest rates and exchange rates are stable. They are used, as a rule, for currency hedging at the exchanges.
8. Hedging through diversification
Diversification is a method of distributing investment capital to various financial assets, the main ones being stocks, bonds, exchanges futures and options, property, bank deposits, precious metals, etc. You can use them to substantially reduce investment risks, which is essentially hedging.
Diversification is an excellent hedging strategy to manage production, commercial, financial and investment risks. However, the impossibility of reducing systemic risks is a drawback.
An example of hedging
We decided not to review all hedging strategies in detail, but instead take the most frequently used transactions of this category involving futures contracts for E-Mini S&P 500 stock index aimed at the protection of a portfolio of shares from a decline in value.
Initial data:
Let’s assume that we have a portfolio of shares from the E-Mini S&P 500 index for the total amount of $500,000;
We expect the market to decline in the near future, but we don’t want to get rid of our stock portfolio, because we expect the prices to increase long-term;
The current value of an E-Mini S&P 500 futures contract is 3,900 pips;
We want to use the E-Mini S&P 500 contracts for the protection of the portfolio against the imminent correction on the market.
Let's determine the number of contracts that will be used in the hedging trade:
Step 1. Calculate the nominal value of a contract = price x multiplier = 3,900 x $50 = $195,000.
Step 2. Divide the total value of the portfolio by the obtained value: $500,000 / $195,000 = 2.56.
In order to hedge a long stock position, we will sell three E-Mini S&P 500 futures contracts (round up at 2.56) by opening a short position.
Let’s assume that the forecasts regarding the decline in the stock price came true and the index and our portfolio of shares lost 5% as a result of correction. Futures value will also drop by 5%. After the decline they will be traded at 3,705 pips (down by 195 pips).
The result of the hedging strategy is as specified below:
At the same time, our short positions on futures brought $29,250 income.
Calculation: (3,900 — 3,705 pips) x $50 x 3 contracts = +$29,250 (profit).
TOTAL:
Drawdown in stocks = -$25,000 |
Income from futures contracts = +$29,250 |
TOTAL = +$4,250 |
|
As you can see from the example, collateral on futures contracts covered the losses on shares and even managed to ensure an income. Of course, hedging strategies do not always work in such a perfect way, but the point is clear.
What is the cost of hedging?
It is important to understand that in the majority of cases hedging does not imply full elimination of the risks, but only an optimal ratio between the benefits of hedging and its cost. You always need to estimate the losses you will incur if you refuse to hedge your risks. If the losses are insignificant, the benefits of such a transaction could turn out to be much smaller than its costs. The hedging price includes the cost of transferring contract settlements, commissions, account maintenance, etc.
It is important to know that consequences of hedging currency risks or any other risks are symmetric. It means that if you earn a profit on one position, there is a probability of incurring a loss on the other position. Hedging costs are rather insignificant and can be disregarded compared to other expenses.
How to start hedging? A step-by-step guide
Once you learn various types of hedging strategies, you will have to choose your own, using the following methods to increase profitability and safety of trading transactions:
Limit Orders to lock profit and limit losses — Stop loss, Take profit, Buy stop, etc.;
Diversification;
In-depth analysis of traded assets;
Improvement of the working capital system, development of a strategy;
Maximum use of past experience and practice in decision making.
There is no universal guide on how to hedge currency and other risks. Existence of various methods of capital management required detailed analysis and selection of the most optimal variants in a specific risk situation.
Best brokers to work with
According to the reviews of speculators, RoboForex and eToro are the best brokers to work in the financial markets with an opportunity to use various hedging strategies.
RoboForex
RoboForex is an international broker that offers access to trading all types of financial instruments – over 12,000 assets. The company was founded in 2009 and is regulated by the Belize IFSC (license for trading financial and commodity derivatives and other securities). In addition, RoboForex is a member of the Compensation Fund of the Financial Commission with a protection of up to EUR 20,000. RoboForex clients do not suffer from the lack of trading platforms. The company offers MetaTrader 4, MetaTrader 5 and more specialized R Trader and cTrader. Transactions can be made on stock CFDs, Forex, etc.
eToro
eToro offers low fees and commission rates, free insurance of up to $1M dollars, ready-made investment portfolios, and more.
When it comes to spreads, eToro’s most common spreads are USD/EUR and USD/JPY, to a low of 1 PIP. As far as FCA regulations are concerned, the company registration no. is 7973792. It is authorised and regulated by the Financial Conduct Authority (FCA) under firm reference number 583263.
In terms of broker reliability, eToro serves as an agency broker or market-marker. These funds and accounts are kept secure via tier 1 banks. The platform acts as a counterparty to trades. Users are in total control of their overall account settings and receive support as needed.
Conclusion
Success of hedging currency risks can be achieved through the following factors:
Correct identification of risks subject to hedging;
An understanding that there are always risks;
Optimal selection of hedging tools;
Development of hedging strategy;
Cost assessment for hedging and comparison with the expected results;
Use of innovative hedging strategies;
Use of the instruments of global stock exchanges, which will ensure high liquidity.
The advisability of using hedging strategies is undeniable. It is impossible to achieve positive results in the market without them.
FAQs
What is hedging in simple words?
To put it simply, hedging means methods that provide protection from unfavorable price fluctuations of a position through entering into premature futures transactions, the fictitious nature of which is known in advance. Basically, this means arbitrage.
How does hedging take place?
Generally speaking, hedging involves the use of futures transactions. They allow market participants to reduce the risk level of future transactions on purchase/sale of assets, while reducing the possible profits and losses from such transactions at the same time. The mechanism implies balancing between transactions in the capital market (commodities, securities, currencies) and opposite futures, options and other contracts.
What is hedging about?
Hedging is about insuring risks through their early prediction and minimization, not through their coverage with retained funds.
What can be hedged?
It depends on the context of the question, the exchange that is being used, trading strategy and investment instruments. Technically, only a position that is a multiple of a futures lot can be hedged, but there are other methods.
Team that worked on the article
Andrey Mastykin
Author, Financial Expert at Traders Union
Andrey Mastykin is an experienced author, editor, and content strategist who has been with Traders Union since 2020. As an editor, he is meticulous about fact-checking and ensuring the accuracy of all information published on the Traders Union platform. Andrey focuses on educating readers about the potential rewards and risks involved in trading financial markets.
He firmly believes that passive investing is a more suitable strategy for most individuals. Andrey's conservative approach and focus on risk management resonate with many readers, making him a trusted source of financial information.
Olga Shendetskaya
Author and editor at Traders Union
Olga Shendetskaya has been a part of the Traders Union team as an author, editor and proofreader since 2017. Since 2020, Shendetskaya has been the assistant chief editor of the website of Traders Union, an international association of traders. She has over 10 years of experience of working with economic and financial texts. In the period of 2017-2020, Olga has worked as a journalist and editor of laftNews news agency, economic and financial news sections. At the moment, Olga is a part of the team of top industry experts involved in creation of educational articles in finance and investment, overseeing their writing and publication on the Traders Union website.
Olga has extensive experience in writing and editing articles about the specifics of working in the Forex market, cryptocurrency market, stock exchanges and also in the segment of financial investment in general. This level of expertise allows Olga to create unique and comprehensive articles, describing complex investment mechanisms in a simple and accessible way for traders of any level.
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Mirjan Hipolito
Cryptocurrency and stock expert
Mirjan Hipolito is a journalist and news editor at Traders Union. She is an expert crypto writer with five years of experience in the financial markets. Her specialties are daily market news, price predictions, and Initial Coin Offerings (ICO). Mirjan is a cryptocurrency and stock trader. This deep understanding of the finance sector allows her to create informative and engaging content that helps readers easily navigate the complexities of the crypto world.