Weekly Lesson Wednesday📝 

Beginners guide to Hedging ✂

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Get your clippers out ✂

Although it may sound like the term "hedging" refers to something that is done by your gardening-obsessed neighbor, when it comes to investing hedging is a useful practice that every investor should be aware of. In the stock market, hedging is a way to get portfolio protection—and protection is often just as important as portfolio appreciation.

Hedging is often discussed more broadly than it is explained. Even if you are a beginning investor, it can be beneficial to learn what hedging is and how it works.

Lets dive in !

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What is hedging 🤷‍♂️

The best way to understand hedging is to think of it as a form of insurance. When people decide to hedge, they are insuring themselves against a negative event's impact on their finances. This doesn't prevent all negative events from happening. However, if a negative event does happen and you're properly hedged, the impact of the event is reduced.

In practice, hedging occurs almost everywhere. For example, if you buy homeowner's insurance, you are hedging yourself against fires, break-ins, or other unforeseen disasters.

Portfolio managers, individual investors, and corporations use hedging techniques to reduce their exposure to various risks. In financial markets, however, hedging is not as simple as paying an insurance company a fee every year for coverage.

Hedging against investment risk means strategically using financial instruments or market strategies to offset the risk of any adverse price movements. Put another way, investors hedge one investment by making a trade in another.

 ⭐EXAMPLES⭐

Hedging techniques generally involve the use of financial instruments known as derivatives. Two of the most common derivatives are options and futures. With derivatives, you can develop trading strategies where a loss in one investment is offset by a gain in a derivative.

Suppose you own shares of a Tequila Corporation (ticker: TC). Although you believe in the company for the long run, you are worried about some short-term losses in the tequila industry.

To protect yourself from a fall in TC, you can buy a put option on the company, which gives you the right to sell TC at a specific price (also called the strike price). This strategy is known as a married put. If your stock price tumbles below the strike price, these losses will be offset by gains in the put option.

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Disadvantages 😐

Every hedging strategy has a cost associated with it. So, before you decide to use hedging, you should ask yourself if the potential benefits justify the expense. Remember, the goal of hedging isn't to make money; it's to protect from losses. The cost of the hedge, whether it is the cost of an option–or lost profits from being on the wrong side of a futures contract–can't be avoided.

While it's tempting to compare hedging to insurance, insurance is far more precise. With insurance, you are completely compensated for your loss (usually minus a deductible). Hedging a portfolio isn't a perfect science. Things can easily go wrong. Although risk managers are always aiming for the perfect hedge, it is very difficult to achieve in practice.

All the same it is definitely a great technique and can save your ass in certain situations.

Thank you
That’s All Folks

Thank you for reading. Like usual. Not financial advice.

Full disclaimer here

Cheers,