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Risk management is one of the most important aspects involved in trading. If you do not have a risk management system in order there can be irreversible and huge losses due to poor decisions. Once the risks are understood and assessed they can be managed and taken care of.
In our day to day lives insurance is a product that manages various types of risks like flood insurance, fire insurance, accident insurance etc. Insurance in layman language means transferring the risk that may or may not occur to some other party for a fee which is negligible as compared to the actual loss that may occur.
Hedging is comparable and somewhat similar to an insurance. A person may hedge his investments via various ways in order to minimize or completely eliminate his potential losses. Hedging eliminates the potential losses, however, at the same time, the downside to this is that there won’t be profits too. A person who is skeptical about the future prices of his stocks is the most likely to hedge his investments rather than a risk taker.
One of the methods to manage risks in investments in stocks is hedging via derivatives. A derivative is a financial instrument which derives its value depending on the value of the underlying assets. Hedging in stocks can be done very efficiently via derivatives. There are basically two methods of hedging using derivatives :
Hedging using futures
A futures contract is the one in which the price is predetermined and the parties to the contract agree to honour the contract at a specified time in the future. Hedging via futures is a good way to eliminate losses. Say for example I own 100 shares of XYZ Ltd. of Rs.100 each. The company is primarily in pharmaceutical business and has filed to sell a new drug in the USA market. However, I assume that it is quite impossible for the company to get a certificate from the USFDA for the particular drug. If the company doesn’t get the certificate the share price may take hit and fall sharply. In this situation, I could hedge my risk using futures of the same company. In order to hedge my risk, I simply take a counter position in the futures market. If I am long on the spot price of XYZ Ltd. I will be short on the futures of the same company. Irrespective of the price movements, since both the positions, are countering each other i.e. they are inversely related, the risk is managed and there are no profits or losses.
Hedging using options
In options trading, the contract offers the buyer, the right and not the obligation. Hedging via options minimizes the losses and caps it. In the same example as above, say I buy a put option of Rs.100 with a lot size of 100, at Rs.3 premium per share. This way I have paid Rs.300 to buy the put option. Thus, my losses are capped at Rs.300 in total. If the price goes down to Rs.90 in the future I will sell my put option and fortunately, if the price of XYZ Ltd. shares goes up then I won’t be obliged to sell at Rs.100 but at the current market price.
Hedging is a great way to minimize or nullify one's losses and can be effectively used in volatile markets. Hedging enables the traders to create a safety net for themselves so that if there is a fall, that particular net saves them.