Any investment portfolio whether it is of the stock market or other, is often associated with different types of risks.
No one knows when there may be a stock market crash but to cope with it, we can take certain measures to minimize the stock market risks by using tested and certified tactics.
The most appropriate way to save your portfolio from the stock market crash is hedging and diversification.
Whether you are planning to pick an individual stock or ETF investing, a lot of hedging strategies can be used to minimize the downside risks and other risks as well.
Hedging in finance refers to a list of strategies that help us to reduce the risk of uncertainties while monitoring our current finances.
Hedging tactics help investors to limit their strategies arising because of ups and downs in the price of the investment.
In short, hedging in the stock market acts as a safeguard against the losses occurring from the investment strategies.
Understanding Hedging with an Example
Portfolio hedging is a list of strategies used by investment managers that mitigate the risks of adverse price movements in an asset.
For example: if we have an open position in the stock that is trading at Rs. 200, but due to some negative news circulating in the market regarding the stock, the price of the stocks has fallen.
Now, to mitigate the losses, we can choose an alternative path by taking a short position in the same stock in the derivative market.
You can implement a hedging process by buying another asset that has the ability to give you high returns with less time or by short selling an asset. Many investors use short selling during the stock market crash as they find the best way to overcome the potential losses.
It may be noted that hedging is used to reduce or minimize the losses but it cannot eliminate the complete risks associated with the stocks. Hence many investors only hedge a part of their portfolio so as they can save themselves from a complete loss.
Tools for Hedging
Derivatives
Derivatives are the most effective hedging tool that is used against their underlying assets. Traders mostly use derivatives as a strategy where the loss for one investment is compensated by the gain of incomparable derivatives.
Derivatives are the financial contracts that derive their value from an underlying asset such as stock, commodity, currency or more. An option is a type of derivative that gives you the right but not an obligation to buy or sell a specific stock within a particular time.
Using Derivative as a Hedging Tool
Let’s consider a hypothetical situation, where you bought a stock with a belief that the price would go up. At the same time protect your stocks against the losses if the prices move down.
Here, we can hedge several risks associated with a stock with a put option. In a put option, we can have the right to sell the stock at the same price. For that, you have to buy a premium.
If the price of the stock falls, then we can exercise the put option and bring back the amount we invested minus the premium amount that we paid for the put option.
What if we have not used the premium option?
If we couldn't use the premium option as a hedging tool here, we would have lost the full investment amount.
Using diversification as a hedging tool
Another hedging tool we can use is “Diversification”. In this strategy, we add multiple stocks to our portfolio that doesn’t rise or fall simultaneously. If the price of one asset collapses, the others remain safe. For instance, to minimize risks, many investors own bonds to compensate for the losses occurring from the stocks.
Thus when the stock price falls, the bond prices rise or vice versa.
Below are the 5 hedging strategies commonly used by investment managers to minimize the risks:
1. Forward
The forward contract refers to the agreement in which traders can buy or sell underlying assets at a fixed price on a date that is pre-defined by the two parties. Forward contracts include many contracts such as forward exchange contracts for currencies, commodities and more.
2. Futures
A futures contract refers to a contract where two parties agree to buy and sell a particular asset at a predetermined price at a specified date in the future.
3. Money Market
A money market is a type of financial market where short term buying and selling can be made with financial assets that are having a maturity of one year or less such as selling, borrowing, lending with a maturity of one year or less.
Strategies of Hedging
1. Asset Allocation
Traders use asset allocation to diversify their portfolio with more than one asset class used. For instance, traders can invest 60% in equity and the rest 40% in other asset classes such as bonds, derivatives in order to have a balanced portfolio.
2. Structure
Traders can invest a part of the portfolio in debt and others in derivatives. As the debt portion maintains the stability of the portfolio, derivatives on the other hand protect the portfolio from the downside risk.
3. Options
The option is a good strategy that helps traders to buy a put option to reduce the losses from the equity market.
Takeaway
Hedging is used to overcome potential losses in the stock market. A hedge is an investment that protects our finances from a risky situation. It is done for minimizing the chance that your asset will lose its value and also limits our losses to a known amount if the asset does lose value.
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