Minimise Risk and Maximise Returns – Explore Hedging!
Investing in the stock market can feel like being on a seesaw. Sometimes, the market goes up, and sometimes it goes down. Just like a seesaw, your financial situation can sometimes feel unsteady, and when things start going down, you might want to jump off the seesaw.
But remember, just like jumping off a seesaw suddenly can leave you off balance and regretful, selling your stocks too quickly can leave your investment strategy shaky, and you might miss out on potential gains.
Don’t worry; you are not the only one who goes through these ups and downs when you invest. Even legendary investors have been through it. The difference is they know how to manage and mitigate risks. This technique is called ‘hedging’.
In this article, we will explore the world of hedging strategies and see how you can lower risks and have a more peaceful investment journey.
What is Hedging?
Hedging is a very useful strategy to limit losses. When the markets are too volatile, and you predict potential risks to your investments, you take a hedge position.
But how does it work? Well, when you hedge, you are making a strategic move by taking an opposite investment position. This counter-position serves as your shield from the downpour of potential losses. Even if your primary investments face adverse conditions and experience losses, the gains from your hedged position can help balance the scales and mitigate risks.
Why do Investors Take Hedge Positions?
1. Risk Management and Loss Limitation
Investors use hedging strategies to shield their portfolios from market volatility and sudden price fluctuations, reducing potential losses. It also enables investors to offset losses in their existing investments by taking positions that move inversely, helping to minimise downside risk.
But remember, hedging is not something that is done mandatorily. It is only done when things look uncertain, and the risk level is too high.
2. Capital Preservation and Stability
Investors who have invested a lot of money into a single investment take a big risk because all of their capital is at stake. To protect and secure their investment, they use hedge positions. These hedge positions help investors lower their portfolio’s overall ups and downs, making their returns more stable and predictable.
3. Diversification and Risk Mitigation
Hedging can be a part of a larger strategy where investors diversify their investments. This means they use assets that don’t move in the same direction. It helps to lower the overall risk in their investment portfolio. Additionally, for traders and investors using leverage (borrowed funds), hedging can help mitigate the increased risk associated with leverage, reducing the potential for significant losses.
Hedging Strategies Investors Use to Reduce Risk
Let’s talk about a common hedge strategy that Indians use knowingly or unknowingly. You see, gold is a popular choice for hedging in India. It tends to perform well when the stock market faces challenges. Additionally, it serves as a hedge against inflation.
Gold is like a safe haven, protecting your investments from potential losses when the market goes through rough times.
During economic uncertainty, gold prices often rise, which can offset losses in your other investments. You don’t have to look too far for an example – during the Israel-Hamas conflict, gold prices increased by nearly 3% overnight and recorded the highest weekly gain in the past seven months. Similarly, we have seen gold rallies during uncertain times, such as the Russia-Ukraine conflict or the US debt ceiling problem. Gold has consistently proven to be a superstar during challenging periods.
To hedge your portfolio with gold, you can consider investing in gold Exchange Traded Funds (ETFs) or Sovereign Gold Bonds (SGBs). SGBs, in particular, offer the additional benefit of interest income and capital appreciation, making them an attractive choice for hedging.
A put option is like a safety net for your stock investments. When you purchase a put option for a stock you own, it grants you the right to sell it at a specific price, regardless of how much the stock’s value drops in the market.
We know this might be complicated to understand, so let’s break it down. Imagine you own shares of a company, and you strongly believe that the stock’s price will decline. However, you don’t want to sell the stock, and you certainly don’t want to see huge losses. This is where a put option becomes useful.
By acquiring a put option for that stock, if the price of your shares decreases, you will profit from the put option. This means it can either offset your losses entirely or, at the very least, reduce those losses significantly.
We all know how ETFs work – they typically track or mirror the performance of a benchmark index. For instance, a Nifty ETF would replicate the performance of the Nifty 50 Index. If the Nifty 50 goes up by 1%, your ETF would also see a 1% increase.
However, when you anticipate that the benchmark index will decline, you can consider investing in an inverse ETF instead of simply watching your investments shrink.
When the market heads downward, the value of your inverse ETF rises.
Inverse ETFs are designed to provide returns that move in the opposite direction of a specific index or asset. They can be used to safeguard your existing investments. But remember, inverse ETFs are not currently traded in India. They are used worldwide as a risk-mitigation tool to hedge against market declines.
So, what is used instead of inverse ETF in India? That brings us to our next point – Shorting or selling index futures.
4. Selling Futures Contracts
Selling futures contracts is a very commonly used practice in India. Here, an investor commits to selling a specific asset, such as an index, at a predetermined price on a future date. They can profit from a declining market by taking a short position in a futures contract.
Again, this is complex, let’s simplify it. Imagine you own a portfolio primarily consisting of Nifty 50 stocks. Lately, you have noticed signs indicating that the market might become more volatile, and you are concerned about your investments losing value.
You can employ a strategy called ‘selling futures contracts’ to protect your investments. This strategy is similar to using put options.
By selling Nifty 50 futures contracts at a specified price, you can generate profits if the market experiences a decline from the price at which you have sold the contract.
However, knowing that trading in futures and options can be highly risky is crucial. If you are new to this strategy, you should seek guidance from a financial advisor who can help you grasp the mechanics and risks of futures contracts.
In conclusion, hedging is a valuable tool for investors to safeguard their portfolios from potential losses. But remember, it is crucial to clearly understand the risks and costs associated with each hedging strategy.
*The indices and strategies mentioned are for information purposes only. This is not an investment advice.
Note: This article was originally written by Teji Mandi for ET Markets.
Read the article here .