Hedging with derivatives: what is it and how is it done? MintGenie explains

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Hedging is a form of investment made to reduce the risk of unexpected price changes of an asset. Usually, hedging involves taking a position opposite to the investment being hedged. It is sometimes compared to an insurance policy. When someone buys a house, they want to protect it from unpredictable situations like a fire. By taking out fire insurance – for which he would pay a premium – he can mitigate the losses he would incur in the fire.

It is important to note that coverage, like insurance, comes at a price. Investing in hedging leaves proportionally less money to invest in the hedged asset. But still, investors tend to do this to minimize risk.

Hedging via derivatives

One of the most common hedging methods is to use derivatives. Derivatives such as options, swaps, forwards and forwards invariably move in the same direction as the underlying asset. Interestingly, the availability of a range of derivative contracts allows investors to hedge them against almost any type of investment: stocks, commodities, indices, currencies, bonds or interest rates. Derivatives are considered effective hedges against their underlying assets.

Sometimes investors use derivatives to build a trading strategy where the investment loss can be recouped by a gain in a derivative contract. For example, when Ms. A buys 100 shares of ABC at 10 per share, she might hedge her investment by buying a put option with a strike price of 7 expiring in six months. This will allow him to sell the shares at the reduced rate of 7 at any time over the next six months. If she has to pay a premium of 1 Re per share for the option, then 100 will be the cover cost.

If the stock price rises in the next six months, she will not exercise her option, but if it falls to 3 per share, then she will exercise her option and sell her shares for 7 per share, resulting in a loss of 300 on stocks, plus 100 on bonus, which makes a total of 400. But without coverage, the loss would have been much higher at 1,000.

It should therefore be remembered that hedging is a strategy that has a price and that aims to prevent, or at least minimize, losses. Moreover, hedging is imperfect and although it is based on calculated risks, it may not work.

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