• 2021-08-30
Hedging

Advantages and Disadvantages of Hedging

Hedging is essentially a risk management strategy that is used in the stock market by investors to either mitigate or reduce the risk of loss that may crop up from the price fluctuations of the currencies, securities, weather, commodities, assets and liabilities. In simple terms, it is the transfer of risk without purchasing any kind of insurance policy.


In hedging, an investor or the speculator, primarily take an opposite position, which has been created in the spot or physical market. It means that if an investor enters into a contract and takes the decision to transact a physical commodity or financial instrument at a particular price, which has been agreed upon today and the payment, is made at the future date.


Derivatives such as Futures and Options can be used for hedging your investments. The volatility in the price levels of your cash position can be balanced out from your positive in derivatives. For example, a rice farmer can decide to sell the rice futures to safeguard the crop value before beginning to harvest. In case, there is a considerable decrease or fall in the prices, then the loss, which the farmer may have to suffer in the cash market position will be balanced by the profits in the futures position.


Advantages

Common advantages of hedging are as given below:


Limits your Losses

The main reason for practising hedging that it allows you to limit your losses. For instance, if an individual purchase a new car and insures it by taking car insurance, then it is essentially hedging against the risk that may crop up because of damage to the vehicle due to the accident, fire, floods and so on. Hence, if a car gets damaged due to an accident and you suffer losses amounting to Rs 10,000. If the insurance company is ready to endure the loss of Rs 9,000, then the loss of an individual is only Rs 1,000 and not Rs 10,000 because of hedging.


Secure your Profits

When you can limit your losses, you can also secure your profits. Speculators that indulged in hedging activities not only can limit their losses but can also secure their profits too. Let’s suppose, an individual has 1000 shares of Company A at Rs 500 per share. In the cash market, the shares are currently trading at Rs 550. If the share of Company A is trading at Rs. 560 then the individual can easily sell the share in the futures market at Rs. 560. In that case, the individual will no longer need to worry about the share price after a month.


Increase Liquidity

Investors who often indulge in hedging, prefer to invest in different asset classes such as equities, commodities, derivatives, and so on. This is what helps them to minimize losses due to increased liquidity.


Disadvantages

Common disadvantages of hedging are as given below:

Costing

The main disadvantage of hedging is the additional cost associated with it. When you hedge your investments with derivatives, you have to pay a certain amount either as premium or brokerage, which may eat up your profits. So, when hedging, always ensure that your profit target is higher than the overall cost. For small investors, it could be an unnecessary expense. Because, in short, it limits your profits.


Difficult for the Short-Term Traders

For the investors, especially for the day traders, who invest in the market on a short-term basis, hedging may not turn out to be a profitable activity because the stock market is extremely volatile and they are not able to keep track of the market consistently. To carry out hedging successfully, excellent trading skills and experience is an utmost necessity.


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