Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2023-05-16T13:46:46+05:30
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Hedging strategies are used by investors to reduce their risk exposure in the event that an asset in their portfolio experiences a sudden price decline. Hedging strategies, when used correctly, reduce uncertainty and limit losses while not significantly reducing the potential rate of return.

Typically, investors buy securities that are inversely related to a vulnerable asset in their portfolio.
 In the event that the vulnerable asset's price moves in the opposite direction, the inversely correlated security should move in the opposite direction, acting as a hedge against any losses. Some investors also consider buying financial instruments known as derivatives. Derivatives, when used strategically, can limit investors' losses to a set amount.

Classic hedging tools include put options on stocks or indices.

What is Hedging?

A hedge is recognized as an investment status that functions to limit the potential losses that investors might suffer through associated investments. Investors that are passionate about market-linked instruments generally make use of hedging. Hedging requires extensive investing in two distinguishing instruments during unfavourable correlation. Availing of car insurance for protecting your car from damages that may occur due to potential accidents is one of the best examples of hedging.  

Hedging tactics are used by individual investors as well AMCs (asset management companies) for the sole purpose of limiting or eliminating risks to get rid of potential negative encounters. While hedging may not completely prevent investors from encountering losses, they significantly recreate the extend of the losses. Here are 5 areas where hedging is used

1) Interest Rate - This area revolves around borrowing and further lending rates. The risk involved with the interest rates herein is recognized as the internet-rate risk.

2) Securities Market - This area involves all sorts of investments that are made in equities, shares, indices, etc. Here, the risk associated with trading is called securities or equity risk.

3) Commodities Market - This area involves energy products, metals, farming products, etc. The risk involved in this type of investment is called commodity risk.

4) Currencies - argue area involves foreign currencies and includes several correlated risks such as currency and volatility risks.

Different Types of Hedging Strategies

1) Futures Contract - This type of contract is made between two standard parties for purchasing and selling assets at an agreed price rate and date. This includes several contracts like a currency futures contract.

2) Forward Contract - This type of contract is made for two parties for investing in or selling assets on a respective date, at a respective price. This includes contracts like forwarding exchange contracts for currencies and commodities.

3) Money Markets - These markets include selling, short-term buying, lending, and even borrowing that happen with maturities of a year or less.

How Do Traders make Hedge Investments?

1) Structure - This takes place when the investor invests in a specific portion of the debt instruments portfolio and the remaining derivatives. Investing in debt thus offers security to this portfolio whilst investing in different derivatives secures you from potential risks.

2) Asset Allocations - This takes place by broadening an investor’s portfolio through distinguishing classes of assets. This thus balances all of your investments.  

3) Via Options - This strategy involves options of calls and further shuts down assets. This allows you to protect your portfolio directly.

Perks of Heading

1) Hedging enhances liquidity solely because it allows investors to invest in different asset classes.

2) Hedging reduces or mitigates losses to a significant extent.

3) Hedging needs a much lower margin outlay, due to which it provides a flexible cost mechanism.

Bottom Line

Hedging offers traders and investors a means to limit potential market risks and volatility. It ensures minimizing potential risks of losses and, it thus gives investors a chance to make profits. This was everything you needed to know about hedging.

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