Hedging can be said to be a technique used by investors to protect against loss via a compensatory price action. Hedging techniques is what actually differentiates a professional from a newbie trader. This makes it so easy for many pro traders out there to survive the financial market and make profits from stock and option trading over the years.
This technique was derived from a term to hedge with a sole aim of minimizing or eradicating financial risk. It evidently is a calculated preemptive installation of guards and insurance within a portfolio in order to revert any unwanted actions.
In ordinary terms, hedging can simply be the purchase of a bullish stock which would go up as the current stocks fall. A stock for a firm KLU that has been profiting and an investor wishes to protect the stock in verge of a decline, hedging allows you to buy a stock of GHT, that has a potential to rise $0.05 if that of stock KLU drops by that same point. Invariably, this safe guards firm KLU during a decline as your stocks position would rise in company GHT.
In the ideal world we can hardly get a scenario as perfect that explained above to serve as our hedging trade. Traders employ the use of derivatives like stock options. The most effective tool for stock options as a hedging tool is in an option trading strategy called the Married Put” or Protective Put.
The Option trading strategy is such that a contract of put option is purchased per 100 shares. For this type of stock options we see a $1 rise trigger the same drop in the underlying stock, hence hedging any kind of loss incurred by the stocks. Even newbie traders can delve into handling positions of stocks against loss, as the cost of purchasing the put option in this vein can be correlated to insurance purchase for your shares.
We must not forget that even after hedging a position, understanding how it works is very vital as we see a lot of big institutions out there hedge. A simple example is when oil firm hedge against oil prices, as opposed to mutual funds that would hedge against FX rates movements.
Investment is important, but yet risk is an element that can hardly be excluded from investment vehicles. It does not matter the kind of investor you choose to become, but the truth is that having a good understanding of how hedging works places you better in a world of constant economic changes that invariably needs protections against the shocks that follows such changes.
Learning how to hedge would greatly make you a better investor.