Are you looking for an ideal trading strategy to help you with increased profits from the stock market? Then, check out this article to learn more about hedging.
The word hedging might make you think of gardening practices. But in the stock market, this word has a whole new meaning. It protects your portfolio against the unpropitious moments of price.
Quite incomprehensible, right? Let's understand with an example: you might have heard of life insurance policies and how they articulate about protecting your family in case you die. Although it won't save you from dying, it somehow reduces the financial impact on your family.
A similar thing goes for hedging since their basic meanings are the same, but hedging is far more complicated than life insurance. It's a technique that judiciously uses investment instruments to counterbalance any risk emerging from adverse price movements.
So investors, whether beginners or advanced, should be aware of this helpful technique. stock market trading courses in Delhi will further help you with the market tricks.
Hedging is nothing but a risk management strategy used by an investor to secure his investment from being lay-bare to a risky situation that may lead to the loss of value.
Through this strategy, the investor covers themselves from all the unforeseen dangers & adverse events of every investment he invests in. For some reason, if a bad event happens and an investor is appropriately hedged, then the outcome of the event is minimized.
Also Read- Benefits of Stock Market Course for easy tips to increase your profits.
Hedging is broadly classified into three types which aid investors in making money by trading in different currencies, securities & commodities. These are:
Purchasing, borrowing, short-term lending, and selling with a maturity period of one year- all these are the components of the money market. Money markets enclose a broad range of financial transactions like trading of currency & calls on stocks.
These are the standardized agreements required between two independent parties who wish to sell or acquire underlying assets on a specific date and time at a predetermined price. It also includes a variety of contracts, such as
Commodity's future contracts.
Currency future contracts & etc.
These are the non-standardized agreements required between two independent parties who wish to sell or acquire underlying assets on a specific date and time at a predetermined price. It includes a wide range of contracts, such as
Forward exchange contract for currencies.
Forward exchange contract for commodities & etc.
Including foreign currencies, are associated with numerous risks, such as volatility risk, currency risk, etc.
Includes metals, agriculture items & energy products that are associated with commodity risk.
Security risk or equity risk includes investment in equities, bonds, stocks, and indexes.
Hedging works as a balance that supports any investment.
Derivative or contract is the standard form for hedging used by investors to measure an asset's underlying value.
Let's say, for example, an investor buys the stock of any company with the hope that that stock's price will increase. But unfortunately, the price plunged, and the investor was left with a loss.
Now to alleviate such incidents, investors can choose an option that will balance off the negative impact of such an event.
Here, the word option means an agreement that lets investors buy or sell a stock at a specific price within the prescribed time.
There are various types of hedging strategies that have their unique factors. And if an investor wants to achieve impeccable results, then using more than one strategy is recommended. Algorithm trading will help you generate computerized profit from stock markets which might not be possible for a layman trader to execute.
Below mentioned are the types that every investor should consider:
It is accomplished by diversifying an investor's portfolio across multiple assets.
For Eg: 50% invested in stocks and the remaining 50% in assets to balance your portfolio.
Arbitrage is a straightforward yet incredibly clever strategy.
In this strategy, investors buy a share and immediately sell it at a higher price in the NSE, BSE, and derivative markets. The profit in this strategy is small but steady. Investors in the stock market commonly use this strategy.
Let's take an example; suppose an investor has 10,000 equity shares of TCS whose value is Rs 565 & in the future, the rate of the same share goes to Rs 575, so the investor sells that lot at the increased price.
It is accomplished by investing some amount of the portfolio in debt instruments that ensure stability and the remaining ones in derivatives which protect against various dangers.
It contains asset call and put options, which allows the investor to safeguard his portfolio directly.
The approach of this strategy is straightforward.In this type the investor keeps part of his money in cash to protect his investments from potential losses.
This type of strategy is often used by investors, which involves acquiring more units of a particular product or share even though the CP & SP of the product has declined.
For example, an investor buys more shares of a previously purchased stock if its price drops significantly. Then the profits from the second purchase may offset losses from the first if the price rises between the two buy prices.
One of the most successful investors in the 20th century, Warren Buffet, has defined call and put options as a weapon of mass destruction. In simple words, A call option is a right but not an obligation with an investor that he has to buy stock or underlying assets at a specific price(set price) on or before the expiration of the date.
For instance, on 8th December 2020, the price for one lot of Reliance shares was Rs 1800/share, and the call option for the lot was Rs 2200/share available with a premium of Rs 50.5, which will expire on 31st December 2020.
Now here
The spot price is Rs 1800
The strike price is Rs 2200
Premium is Rs 50.5
In order to exercise the call option, the investor must wait until the price for one lot of shares rises to Rs 2200/share. If the price rises, the seller must sell the lot since he is bound to a contract with the investor.
But if the price doesn't uplift until the expiry date, the investor can cancel the call option by losing his premium amount. A put option, on the other hand, is a right but not an obligation with an investor that he has to sell stock or underlying assets at a specific price(set price) on or before the expiration of the date.
Before going further, let's first understand the primary meaning of CFD.
CFD stands for contract for difference between a broker and an investor. Like stocks, it is also traded on an exchange, but with one significant difference: You don't own the asset you trade. Hedging through CFDs is a widespread practice as they enable traders to make long or short trades without acquiring the underlying assets.
Let's understand this with a hypothetical example:
Mr. Amitabh owns 15000 shares of Tesla on his separate broking account, and he's pretty concerned that the price of the share will drop due to its poor financial report.So, he decided to short-sell his 15000 Tesla shares through his CFD trading account, hoping that if any loss occurs, it can be offset by victorious short trade. Unfortunately, after some time, the price of Tesla shares was fallen by 10%, which made MR Amitabh's account worth less in value. But, his CFD trading account made a gain of 10%, which nullified the loss.With the lower price, Mr Amitabh can purchase his Tesla shares again.
Hedging is used to secure investors' profit.
Allows traders to undergo arduous marketing conditions.
One of the main perks is to increase liquidity in financial markets.
It will enable investors to utilize complicated trading techniques to optimize profit.
Effective hedging protects investors against inflation, interest rates, currency exchange rates, etc.
With multitudinous asset classes, you can diversify your trading portfolio effectively.
With lesser margin expenditure, it provides a more flexible pricing strategy.
It substantially reduces losses.
Investors are allowed to invest in various assets, enhancing their liquidity.
Risk and reward are parallel threads. Lower risk means a lower profit.
Hedging comes with a cost that tends to outweigh the gain.
Traders who engage in short-term trading, such as day traders, find that hedging is a challenging strategy.
The benefits of hedging are minimal if the market is doing well or moving sideways.
Trading options and futures often have higher capital or margin requirements.
It takes good trading skills and experience to succeed with hedging.
These were some basics to understand what hedging is all about in the financial market. As financial markets can change suddenly and unforeseeably, hedges are essential protection for investors who cannot control the manipulation to safeguard their investment. And if you are a newbie investor who wants to be the OG in the stock market and wants to learn various skills.
In that case, There is no better program to gain more knowledge about stocks than the Stock Market Institute In India which has a comprehensive list of courses on the stock market, like BSE, NSE, SEBI, NISM, and NCFM, to help you invest like a bull.
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