Most of the investors never do hedging in share markets. However, it would be good to understand what is meant by hedging with some examples. After all, knowledge is wealth in this century, especially in finance industry.
In simple, Hedging is your mitigation plan to reduce risks. In someway, we can compare hedging with insurance but it is not exactly same. In Insurance, for example insurance against your property, you pay some premium to buy insurance and if something goes wrong with your property then economic value of that property will be paid back to you. That means with a little premium you are transferring almost entire risk to other party (insurance company). But in hedging we can reduce the risk with many limitations.Hedging can only reduce your risk but doesn’t eliminate as in case of insurance. For example, India is importing huge amount of petroleum from gulf countries and the prices of petroleum fluctuate continuously. Say for example, present price is $ 50 per Galleon. Assume government came up with some analysis and believed that the price may go up to $100 per Galleon in a year. If that is the case it will be a huge burden on economy. So, Indian government can make an agreement with petroleum dealers (or thru commodity exchanges) such that government would buy some X Galleons of petroleum at the price of $75 after 1 year (say July 1st 2010).
If the actual price of petroleum after 1 year is $100, government can pay only $75. In that way it has reduced the risk of buying petroleum at high price which it can’t bare. The other side of hedging is, if actual price of petroleum is $40, still government has to bare this loss.
Hedging against investment risk means strategically using available instruments (ex: derivatives) in the market to reduce the risk of any adverse price movements. In other words, investors hedge one investment by making another investment. Technically speaking, to hedge you would invest in two securities with negative correlations.
With this I am concluding below points
Hedging can be used to reduce risks.
Hedging is not speculation to get benefited from it.
Hedging doesn’t work always.
Mohan Bhupathiraju
Mohan Bhupathiraju is a co-founder & editor at LastBull.com. Handled multiple projects in BFSI for few of the Forbes top 100 companies. He works in IT industry in the US. Presently working on start up Ideas in Finance & Technology niches.
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{ 2 comments… read them below or add one }
It’s gallon…..lol
Nice article !!
If I understood the article and the example correctly, then the example refers to futures contract and not to options contract right?
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