What is hedging?

Imagine you're a farmer growing wheat, and you're worried about the price of wheat dropping by the time you harvest it. You want to protect yourself from losing money if the price goes down. So, you make a deal with a buyer to sell your wheat at a fixed price in the future, say 6 months from now. This way, even if the market price of wheat drops, you're still guaranteed to sell your wheat at the agreed-upon price.

Hedging in the stock market refers to a risk management strategy that is used by investors to lower the potential losses that results from unfavourable price movements.

Stock market hedging helps investors reduce risk by using options, futures, or swaps. This can be done on stocks, indexes, bonds, and even commodities.

How does Hedging Work?

Hedging works by taking an opposite position in a related investment. For example the main Investment could be the stock, bond, commodity etc. you already own that you want to protect from price movements. For this the Hedging Position would be a new investment you make that will benefit you if the main investment loses its value, and vice versa.

In the above example here's how hedging can help:

• Main Investment: Your wheat crop. You're hoping for a good harvest and high wheat prices.
• Hedging Position: You can sell wheat futures contracts. These are agreements to sell wheat at a predetermined price (called the strike price) on a specific future date.

Another common example of hedging in the stock market involves using put options to protect yourself from a decline in a stock's price. Here's how it works:

• Main Investment: Let's say you own 100 shares of A company at ₹100 per share. You believe in A’s long-term potential, but you're worried about a short-term market correction that could bring the price down.
• Hedging with Put Options: You can buy put options for A stock. Put options give you the right, but not the obligation, to sell your shares at a certain price (called the strike price) by a certain expiry date.

Imagine you buy put options with a strike price of ₹90 and an expiry date in 3 months. Here's what could happen:

• Stock Price Goes Up: You can simply let the put options expire unused. You'll enjoy the gains on your original 100 shares of A if the price rises.
• Stock Price Goes Down: If the price falls below ₹90, you can exercise your put options and sell your shares at ₹90 each. This will limit your lose compared to just holding the stock and watching the price drop. Even if the price crashes to ₹80, you'd still get ₹90 per share thanks to the put options.

Advantages of Hedging:

1. Risk Reduction: Think of hedging like a safety net for your money. It helps protect you from losing too much if the price movements vary in the markets. By using hedging strategies, individuals or businesses can protect themselves against adverse price movements in assets, currencies, commodities, or interest rates.
2. Peace of Mind: When you hedge, you worry less about sudden drops in prices or rates. It allows individuals or businesses to lock in prices or rates, so they won't suffer major financial losses if market conditions turn unfavourable.
3. Control: Hedging gives you more control over your financial risks. You can choose strategies that fit your needs and comfort level.
4. Price Speculation: In some cases, hedging can be used strategically to speculate on future price movements. For example, an airline might hedge against rising oil prices by buying oil futures contracts, locking in a lower price for future fuel purchases.
5. Reduce Overall Portfolio Volatility: This means the value of your investments won't swing as much, making things less stressful, especially if you don't like taking risks or are close to retirement.

Disadvantages of Hedging:

1. Costs: hedging strategies often comes with costs, such as transaction fees, premiums for options contracts, or margin requirements. These costs can also take away your into potential profits or increase overall expenses.
2. Over-hedging: Sometimes people hedge too much, which can limit their ability to make money when things are going well. It's like being too cautious and missing out on good opportunities.
3. False Security: While hedging can reduce risk, it can also create a false sense of security. You might rely too much on your hedge and not pay enough attention to other risks.
4. It Might Not Work: Despite your best efforts, hedging doesn't always do the trick. Market conditions can be unpredictable, and your hedge might not fully protect you from losses.
5. Complexity: Hedging strategies can be complex, especially for beginners. Understanding different hedging instruments and how to use them effectively requires some financial knowledge and experience

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