Hedging is essentially a risk management strategy that is used in the stock market by the investors to either mitigate or reduce the risk of loss that may crop up from the price fluctuations of the currencies, securities, weather, commodities, assets and liabilities. In simple terms, it is basically transfer of risk without purchasing any kind of insurance policies.
In hedging, an investor or the speculator, primarily take an opposite position, which have been created in the spot or physical market. It means that if an investor enters into a contract and takes the decision to transact a physical commodity or financial instrument at a particular price, which has been agreed upon today and the payment, is made at the future date.
Options and futures are the two prominent derivatives that can be used for the purpose of hedging. A profit or loss in the cash position, mainly due to the fluctuations in the price levels can be quite effectively balanced by the fluctuations in the value of futures position. For example, a rice farmer can decide to sell the rice futures in order to safeguard the crop value before beginning to harvest. In case, there is a considerable decrease or fall in the prices, then the loss, which the farmer may have to suffer in the cash market position will be balanced by the profits in futures position.
Advantages of Hedging
There are some prominent advantages of hedging, which are as follows:
Limits the Loss
The main advantage of hedging is that it helps the people to limit or reduce the loss. For instance, if an individual purchases a new car and insures it by taking a car insurance, then it is essentially a hedging against the risk that may crop up because of damage to the vehicle due to the accident, fire, floods and so on. Hence, if a car gets damaged due to an accident and you suffer the losses amounting to Rs 10,000. If the insurance company is ready to endure the loss of Rs 9,000, then the loss of an individual is only Rs 1,000 and not Rs 10,000 because of hedging.
Protect the Profit
One of the prominent advantages of hedging is that it protects the profits of the investors or speculators who are engaged in the hedging activity. Let us understand it better with the help of a simple example. Suppose, an individual has 100 shares of a Company XYZ at Rs 100 purchase price. In the cash market, the shares are currently trading at Rs 120. Now, the main problem is that an individual is in two minds whether to hold or sell the shares. Now, if the share prices of the Company XYZ are trading at Rs 125, then the investor can sell the shares in the futures market at Rs 125. Thus, an individual is not required to take any stress with regard to price of the shares after one month and the profit of Rs 5 is quite safe as far as the interest of the investor is taken into the consideration.
Increasing Liquidity in Financial Markets
People, who undertake the activity of hedging, generally like to trade in the different markets like the stock market, commodity, derivative and so on. Due to this, they are able to minimize the loss because of the sufficient liquidity in the various markets.
Saves Time
Believe it or not but hedging also helps in saving time of the investors or speculators. This is because an individual who trades for the long-term is not required to keep track of or adjust the portfolio irrespective of the market conditions.
Disadvantages of Hedging
There are some prominent disadvantages of hedging, which are as follows:
Hedging is Not Free
You will be really surprised to know that hedging is not free at all. There are certain costs, which are involved in case of hedging. For instance, if you purchase a car, then you are required to pay a certain premium for the car insurance. Similarly, if you are hedging in the derivatives, then you may have to pay the premium or brokerage that can eat up the profits. Thus, most of the investors, consider hedging as an unnecessary expense.
Limits the Profits
One of the biggest disadvantages of hedging is that is limits the profits of the individuals. For instance, if the share price of the Company XYZ rises to Rs 140 from Rs 125, then a person who is not involved in the hedging activity will get a profit of only Rs 10 and not Rs 15. Hence, due to hedging, an individual will lose Rs 5.
Difficult for the Short-Term Traders
For the investors, especially for the day traders, who invest in the market for the short-term basis, hedging may not turn out to be a profitable activity because the stock market is extremely volatile and they are not able to keep track of the market consistently. To carry out hedging successfully, excellent trading skills and experience is an utmost necessity.
Conclusion
It cannot be said without any doubt hedging offers prominent advantages to the investors to trade in the stock market, provided it is done in the right manner. It must not be forgotten that risk is an integral part of carrying out trading in the stock market and its prominent objective to gain the profits. A very important thing that must be remembered here is that market is uncertain and carrying out the activity of the hedging helps the investors to safeguard themselves from the volatility in the stock market.
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