Hedging strategies are one of the best methods to ensure profits in a volatile market. Though the general public considers hedging to be far too sophisticated for retail or mom and pop investors, hedging is useful for all investors.
Understanding hedging as a way to protect against losing money in an investment simplifies what many believe to be a complex form of investing. A simple example of how an investor might hedge their portfolio is buying put options for a stock that makes up a large part of the investor’s portfolio. If the stock continues rising, then the investor’s portfolio value will continue rising. If this stock value falls, then part of the decrease in value will be compensated for by the increase in the value of the put option.
Explaining the details of put and call options is beyond the scope of this article, but once an investor understands the concept of options, hedging with them becomes easy.
Tip #1 – Hedging strategies are designed to avoid loss more than to provide profit.
The term hedging itself refers to protecting against loss. It would be a mistake to attempt to gain profits through hedging investments. Generally speaking, placing a hedge on your main investment can reduce your profit.
Tip #2 -Hedge to reduce risk of loss in volatile markets
An investor who understands how to hedge has to determine the proper time to hedge versus a bad time to hedge. The best time to hedge an investment is when it has become a significant part of the portfolio or has already gone in the direction of the anticipated trade, making a substantial profit. Hedges can protect the profit.
Tip #3- Options are one of the best hedging tools but not the only method
Futures contracts, buying opposite trend investments, or any other investment vehicle that moves counter your main investment can serve as a hedge. Options are usually the most convenient and often the lowest cost method of hedging.
Picking an investment to balance out another investment means making sure that you are not increasing risk versus decreasing risk. For example, if an investor were to use a futures contract to hedge against an investment in a mining company, the investor has increased their risk of loss to unlimited levels with a futures contract. The investor has incorrectly applied the concept of hedging by increasing risk while lowering profit potential.