What financial instruments can I use for hedging?
There are a range of basic hedging instruments and techniques that can be used to trade financial markets. Discover which methods you can use to protect your portfolio from downside risk.
What is a hedging instrument?
A hedging instrument is any financial product that will enable traders to reduce or limit the risk in an underlying asset class, such as cash, shares, commodities, indices and forex. The practice of hedging a market is essentially a way of taking out protective insurance on your trade or investment – it doesn’t prevent risk entirely but can lessen the blow should things go wrong.
To achieve this, a trader will need to open a position on an asset that will become profitable if one of their other positions starts to incur a loss.
Instruments to hedge with
There are a variety of instruments that can be used to hedge risk, including:
The best hedging instrument will depend on its suitability to your trading plan and what you want to hedge. For example, the instrument best suited for hedging forex positions, might vary from the best instrument for hedging bitcoin risk. Ultimately, it all comes down to your personal preference, risk appetite and trading style.
Hedging with CFDs
A contract for difference (CFD) is an agreement to exchange the difference in the price of an asset between when the position is opened and when it is closed. Hedging with CFDs is an extremely common practice as they enable to traders to go long or short on a market, without taking ownership of the underlying asset.
There are a variety of benefits of using CFDs to hedge. For example, CFDs are a leveraged product, which means that a trader only needs to put down a small initial deposit – known as the margin – to gain full market exposure. This gives hedgers the benefit of being able to open more positions and spread out their capital. However, it is important to note that while leverage does enable traders to magnify their profits – as any gains to the position are calculated based on the full exposure, not the margin – it does also create the possibility of magnified losses.
To get started hedging with CFDs, you can:
- Open an account. You can open an account with IG quickly and easily
- Practise trading on a demo account. Test your hedging strategy in a risk-free environment with an IG demo account
- Develop your knowledge. Join IG Academy to learn more about financial markets
Example of a CFD hedge
Before you can start to hedge with CFDs it is important to known exactly what you’re hedging, in which direction you need to hedge and the position size you need to take.
Let’s look at an example of hedging currency risk. Say you’re a British investment banker working for a US investment bank in London. You’re told at Christmas that you’re going to receive a bonus of $5 million in June, and want to transfer this bonus into sterling. The current rate of cable (GBP/USD) is very favourable, and you don’t want to run the risk of the dollar weakening between now and when you receive this bonus.
You decide to hedge your currency risk with a long CFD trade on GBP/USD – buying the pound, while selling the US dollar. To do this you’d need to work out the position size required to fully hedge your exposure.
Let’s say the current rate of GBP/USD is 1.2800. Firstly, you’d need to convert the amount you want to hedge to the base currency of the relevant currency pair. So, $5,000,000 would give you a £3,906,250 exposure.
One contract of GBP/USD would give you £100,000 exposure, so £3,906,250 would be equal to 39.06 contracts. For CFD clients of IG, one contract of GBP/USD is equivalent to $10 per point, so 39.06 contracts is equivalent to $390.60/point.
Once you’d opened your position, if the dollar weakens against sterling, the profit to the CFD position could balance out the reduction in value of the bonus – however, it wouldn’t be a perfect hedge as you would be exposed to US dollar movements when converting realised profit. If the dollar strengthened against sterling, you would take a loss on your CFD, but your bonus would have increased in value due to the favourable exchange rate.
Hedging with options
Options give the holder the right – but not the obligation – to buy or sell an asset at a specific price, known as the strike price, within a set timeframe. There are two types of options; calls and puts. Call options give the holder the option to buy an asset at the strike price on or before the expiry date, while put options give the holder the option to sell an asset at the strike price on or before the expiry date.
While options are commonly used for speculation, they are an extremely popular hedging tool. This is largely because if the market does not move as predicted, the holder can let the position expire and only pay the price of the option – known as the premium. The premium is the maximum loss that can be incurred.
Options are popular instruments that can be used for hedging share positions, although the principle of applying a hedge in this fashion can be used across different asset classes as well.
Example of options hedging
Let’s assume an investor is holding 100 shares in a company called ABC. The investor believes that the value of ABC will increase substantially over the next few years, however in the near term there is the concern that market volatility could cause short-term weakness in the share price of ABC.
To hedge the equity position, the investor could look at buying put options on company ABC. Each option contract will typically be the equivalent of 100 shares of the underlying asset. So, in this situation, one option contract would be enough to hedge 100 ABC shares.
The premium paid to open the contract would be the maximum loss the investor could incur from the option hedge – meaning the downside risk of buying the put option would have a predetermined limit.
A put option will rise in value if the underlying equity falls in value, so a loss to the investor’s shareholding would – to a varying extent – be covered by a gain in the option value. The extent of a gain would depend on how far the share falls in relation to the strike you chose for the option.
However, if the share price did not fall but rather gain, the investor would benefit from the gain in share price. This would be offset by the premium that was paid to open the option hedge which would now be left to expire as worthless.
Alternatively, let’s say a trader has a short derivative position on ABC shares, looking to benefit from a falling share price. The trader decides to protect against a rise in the share price by purchasing a call as a hedge. The trader would then pay a premium to buy the call option, which would be the maximum loss they could incur should the share price continue to fall.
A call option will rise in value if the underlying equity gains in value, so a loss in the short trade would be covered – to a varying extent – by a gain in option value. Again, the gain would depend on how far the share price falls in relation to the strike price you selected.
Hedging with futures contracts
A futures contract is a legal agreement that requires two parties to exchange an asset at a predefined price, on a specific date. Most futures contracts will require the physical asset to exchange hands, however, they can also be settled in cash.
Futures are most commonly used by producing companies and end-users in order to secure a predetermined price for a product and limit the adverse impact of market fluctuations.
Example of futures hedging
Let’s say a biodiesel company is worried about future volatility in the soybean market because it uses the grain to make its petroleum substitute. If the price of soybeans were to shoot up, it could have a negative impact on the company’s profits and share price.
The company knows it will need one ton of soybeans in six months to fulfil their production quota – the equivalent of 34 bushels. As the spot price is $9.00 per bushel and the six-month futures price is $8.50 per bushel, the company decides to enter into a long futures contract to protect against the uncertainty in the soybean market. This will enable them to secure one ton of soybeans when they need it at $8.50 per bushel (a total of $2830), as the contract has an expiry of six months.
At the time of expiry, if the price of soybeans is above $8.50 per bushel, the biodiesel firm would be able to execute their futures contract and secure the lower price of $8.50 per bushel. But if the price of soybeans falls, say to $8.00 per bushel, they would have to exchange at the higher price of $8.50 per bushel.
What is the best instrument for hedging?
The best instrument for hedging will be the one that suits your trading and investment plans to help you realise your financial objectives. Traders will need to be aware of the cost and transparency of the instrument they are using to hedge an underlying portfolio.
When using products such as futures and options, it is worthwhile noting that these instruments will have expiry dates (although these can be rolled over at a fee) which will need to be correlated to the underlying asset which is being ‘insured’.
CFDs are often considered the best instrument for hedging, as they do not have a contract expiry date – this can be beneficial when longer-term protection is needed.
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