When you have a stock portfolio, hedging the portfolio is very important. Hedging offers downside protection against losses. Stock markets are volatile. Just like how you look for your portfolio appreciation, you should also consider hedging strategies to protect against risk when the markets are on a downward spiral while doing online investing. To put it simply, hedging is a form of insurance against downside losses.
Recently, we have seen how markets have corrected from the lifetime highs achieved in 2021. Sensex 30 achieved a high of 62,245.63, and Nifty 50 a high of 18604. 45. Ever since the US Federal Reserve has announced a complete stop to quantitative easing and the RBI followed suit with a 40 b.p.s in the repo rate, Indian markets have been depreciating in tandem with global markets. The benchmark indices Sensex and Nifty have depreciated almost 12.5% from their respective peaks along with the broader market. Risk is inherent in stock markets, and a prudent policy would be to hedge your risk through online investing.
How do hedging strategies work to hedge portfolio risk?
● Hedging primarily involves taking an opposite position to your portfolio in a related asset to offset your portfolio losses.
● Hedging while reducing risk also has a concomitant reduction in potential profits. This is an indirect cost attributable to hedging.
● Hedging primarily involves derivative products such as options and futures with a direct cost in the form of premium payment.
Different types of Hedging Strategies
· Hedging a stock or a portfolio through options: You can buy a put option to hedge against the risk in individual shares. You can also buy a put option on stock index options to hedge portfolio risk. A put option limits the downside, so you can avoid large potential losses. When the stock or portfolio value reduces, the appreciation in the value of the put option will nullify the losses to a large extent. You can easily buy a put option through online investing.
· Hedging commodities through futures: If you are a trader who expects oil prices to skyrocket and you want to protect against this, you can buy a futures contract through online investing. The futures contract will allow you to buy oil at a specific price/strike price at a future date. Irrespective of the movement in the market prices of oil, your price will always be equal to the strike price contained in the futures contract. Even if the price of oil suddenly plunges, your price of oil will always be equal to the strike price.
· Hedging currencies through a Forward/Swap contract: If you are an exporter, you may want to fix the currency exchange rate for the conversion of the value of exports denominated in foreign currency through a forward contract. Swaps are executed to either swap currencies or for interest rates when you swap fixed rates for floating rates. Forward and swap contracts are OTC contracts normally executed through a bank.
The downside of hedging strategies
Hedging, as previously mentioned, is a risk management strategy or a form of insurance against market downfalls. But a consequence of hedging is that you do not participate in potential upside opportunities. Hedging offers downside protection, but it also limits the upsides. Plus, there is a cost to hedging your portfolios. Despite that, to limit your potential losses during market downturns, you must proactively pursue a policy of hedging through online investing.
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