Hedging is something that Contract for Difference all investors should know how to do. After all, portfolio protection is as equally important as portfolio diversification and portfolio protection.
However, sometimes, beginners think Video Tutorials that it’s something way beyond them, like they will still have to spend so many years in the financial markets just to understand the concept of hedging. That’s not entirely true.
While hedging is more effectively practiced by old-timers and experienced investors, it can also be effectively done by true beginners.
What is Hedging?
Hedging serves like an insurance. If an investor decides to do some hedging, he or she is basically insuring himself or herself against an unfortunate event.
This doesn’t stop that unfortunate event from happening, as is true with other kinds of unpleasant events in the market, but it helps the investor brace and cushion himself or herself better if such an event happens to him or her.
If the event so happens but the investor is sufficiently hedged, the unwanted impacts of the event is lessened.
How is it used?
Different kinds of market participants use hedging in different ways. Portfolio managers, corporations, and individual investors use different hedging techniques to mitigate their exposure to different risks.
Hedging in the financial markets, however, isn’t as easy as it is defined. This is because you practically have to use instruments in the markets strategically to offset the risks of any unfavourable price movements.
Simply put, if you want to hedge, you have to invest in two securities that have a negative correlation. That means you would still have to pay for this in one form or another.
It also means that your chances for higher rewards will be diminished because of the risk-return trade-off. Putting it in another way, you will have to lower your returns if you don’t want to lose more.
In essence, hedging doesn’t really let you get higher returns. Instead, it’s more about minimizing your potential losses, which is still a very good achievement if you accomplish it.
The Downside of Hedging
Those things being said, you always have to weigh things out. You should ask yourself if the safety you get from hedging justify the expense.
The cost of hedging can be about the lowered chances of higher returns or of an option (since more investors hedge away from risks by investing in derivatives such as options and futures) or other hedging instruments.
And there’s no way you can avoid these expenses. If you cannot tolerate too much risk and uncertainty, pushing through your hedging plan might be the better course of action.
What It Means to You
Many investors around the world do not engage in any form of hedging at all. This is because most buy-and-hold investors do not mind short-term price fluctuation a bit. So for them, there’s little to no point to try hedging.
Meanwhile, investors who engage in hedging want insurance, as we have mentioned, since the market is never predictable. Also, having the basic idea of hedging gives you improved awareness of how investors and companies try to protect themselves.
And having a deeper understanding of how market participants behave means having a deeper understanding of how the market behaves, and that is something very valuable in the financial world.