Hedging is a strategy used in finance and investing in reducing the risk of adverse price movements in an asset. Hedging aims to reduce the risk of loss due to price fluctuations. This is typically achieved by opening a position that moves in the opposite direction to the original trade.

Hedging strategies can be complex and can involve a variety of financial instruments, but the basic principle is always the same: to minimize risk and protect against adverse market movements. Hedging strategies come in all different variants of scope and complexity, including long/short hedging, forwards contracts, and futures contracts, all of which can be applied to a wide variety of sectors and asset classes.

To better understand hedging, we will explore some hypothetical hedging strategies and how they contribute to risk management. This information is provided for informative purposes only and should not be construed to be investment advice.

What Are Some Different Hedging Techniques?

There are an abundance of ways in which traders can use hedging to mitigate their risk. Regardless of your skill level, as a trader, you always have the option to hedge your trade as part of your portfolio strategy. Here are two examples of how a trader might use opposing positions to hedge their trades:

Simple Long/Short Hedging

Long/Short hedging is when a trader takes opposite positions in two related financial assets in order to reduce the risk of losses. This strategy involves going long on one asset and short on another, with the expectation that any losses on one position will be offset by gains on the other.

For example, suppose a trader is feeling optimistic about the technology sector and believes that both Apple and Microsoft will continue to grow in the long run. However, they are concerned about short-term market volatility and potential price declines. To hedge the position, the trader could take a long position in one stock and a short position in the other.

For instance, the trader could buy 100 shares of Apple (long position). At the same time, they could also short-sell 100 shares of Microsoft (short position). This means they are borrowing the shares from someone else and selling them with the expectation of buying them back at a lower price in the future to cover the short position.

If the technology sector experiences a short-term downturn, it is possible that both Apple and Microsoft stocks could decline in value. However, with the long/short hedging strategy, any losses from the short position in Microsoft would be offset by gains in the long position in Apple, and vice versa. This is because if Apple's stock price increases, the long position would appreciate, while if Microsoft's stock price falls, the short position will do the opposite. This mitigates risk and gives the trader more options for entry and exit strategies.

Hedging with Forwards Contracts

A forward contract is a type of agreement between two parties to buy or sell an asset at a future date for a pre-agreed price. Forward contracts can be used as a hedging strategy to manage the risk associated with fluctuations in the price of an asset. It may seem more complex than

For example, a trader is holding gold in their portfolio because they believe that the price of gold will increase in the next six months. However, they are also concerned about the risks that the price of gold may decline in the future due to factors like market uncertainty. To hedge against this risk, the trader can enter into a forward contract with a counterparty to purchase gold at a pre-agreed price, lower than the price they bought into their other position.

By entering into this forward contract, the trader has effectively locked in a price for a gold purchase, which provides a degree of certainty and helps you to manage the risk of price fluctuations. If the price of gold declines in the future, you will still be able to purchase gold at the pre-agreed price of $1,500 per ounce, thereby protecting your profits. Equally, however, if the price of gold increases in the future, in this instance, profits will also be mitigated.

Remember, the goal of a hedging strategy is not to maximize profits but rather to manage risk and protect against potential losses. One of the main limitations of forward contract trading is a lack of flexibility as the trader can choose to exit their gold position whenever they like. However, they are obligated to honour the contract on the date specified.