We have recently written a post on The Basics of Risk Management, followed by a detailed article on how to use stop-loss strategies to minimize risk. Today, we shall talk in detail about the other method of risk management, i.e, hedging.
Hedging involves the use of derivatives, or futures and options trading. Futures and options trading is generally considered a highly advanced and complicated investment form and is often criticized because of being speculative in nature. However, their use in hedging is perfectly acceptable, and that’s where we’re going to restrict the scope of their use.
A financial contract is an agreement to purchase or sell an asset in the future at a predetermined price and date.
In simple terms, futures allow you to sell a security you don’t even own and buy one later in the future at a different price from now.
The best way of using futures to hedge risk is the classic ‘pairs trade’, i.e., investing in an opposite position to a security similar to the one you already hold.
When to use
You anticipate a general decline in the market but are optimistic for the long term You’re investing in a company you believe in but whose industry hasn’t proved itself in the market yet