What is hedging and how does it work in trading?

What is hedging and how does it work?

Hedging is the practice of holding two or more positions at the same time with the intent of offsetting any losses from the first position with gains from the other. At the very least, hedging can prevent a loss from going beyond a known amount.

In fact, you might’ve hedged and not even known about it as people hedge in everyday life as well as on financial markets. For example, people view insurance as hedging against future scenarios – as hedging will not prevent an incident occurring, but it can protect you if the worst happens.

Typically, hedging is a risk management strategy used by short to mid-term traders and investors to protect against unfavourable market movements. Many long-term investors never use hedging as they tend to ignore short-term fluctuations altogether, but it’s still important to learn about the process because it can have a range of different applications. 

Why do traders hedge?

Traders might hedge their positions for a number of reasons; whether it’s to protect their trades, their investment portfolio or are looking to combat currency risk. It’s important to understand that when traders hedge, they do so not as a means of generating profit but as a way of minimising loss.

All trading involves risk because there is no way to prevent the market moving against your position, but a successful hedging strategy could minimise the amount you might lose.

Here are five common reasons that traders choose to hedge:

1. To avoid volatility risk on forex positions
2. To avoid liquidating shareholdings
3. To avoid currency risk on foreign assets
4. To avoid concentration risk
5. To protect portfolio value during market uncertainty

Avoiding volatility risk on forex positions

For some, the allure of trading forex is that it’s incredibly volatile and fast paced, but for others, there’s a desire to reduce excessive risk where possible. While many traders will minimise their risk by attaching stop-losses, there are some that choose to use forex hedging strategies. These include:

• Simple forex hedging, which involves taking a long position and a short position on the same currency pair
• Multiple currency hedging, which involves selecting two currency pairs that are positively correlated and taking positions on both pairs but in opposite directions
• Forex options hedging, which gives the buyer the right, but not the obligation, to exchange a currency pair at a set price on a specific future date

Avoiding liquidating shareholdings

Although investors tend to focus on longer-term market movements, some will hedge against periods of economic downturn and volatility, as opposed to liquidating a shareholding.

As an investor, it’s also important to understand the process of hedging because it is a widely used strategy for businesses. So, if you’re investing in an oil company, for example, they might choose to hedge against declines in the price of oil by using futures contracts. Understanding hedging would make it easier for you to make sense of the company’s financial undertakings.

Discover how to hedge your share portfolio

Avoiding currency risk on foreign assets

Currency risk, or exchange rate risk, describes the potentially damaging impact that fluctuations in the value of a currency pair can have. There are a range of ways the term currency risk is applied but it is largely used to describe the negative effects of forex rates on the value of an asset that is being transferred across borders. The risk can apply to properties being sold abroad, overseas salaries and even currency conversion for holidays.

For example, if an individual was going on holiday to the US in six months’ time, they could opt to exchange their currency to dollars at the current rate or wait six months. While they might secure a better rate by waiting, they also might have to exchange at a worse rate – this is currency risk.

To combat currency risk, traders will hedge. Some of the most common ways to hedge currency risk include using options contracts, specialised ETFs and leveraged products such as contracts for difference (CFDs).

Learn more about how to hedge currency risk

Avoiding concentration risk

Concentration risk describes the potential negative impact of having too much exposure to a single investment, sector or market. While this concentration might offer higher returns when things go well, it can also lead to substantial losses if that specific investment, sector or market underperforms.

To combat concentration risk, you could use different types of hedging strategies. Common approaches include diversifying through ETFs, or using options contracts or CFD trading positions to offset potential losses in investments.

Learn more about portfolio diversification

Protecting portfolio value during market uncertainty

Market uncertainty presents significant risks to portfolio value, particularly during periods of high volatility or economic instability. These conditions can lead to sudden market movements and potential losses across multiple assets simultaneously.

For example, during a global economic crisis, even well-diversified portfolios might face substantial downside risk as different asset classes become more correlated. Once again, hedging strategies could help to maintain market exposure while providing protection against potential losses, effectively smoothing out returns during turbulent periods.

Learn more about trading in volatile markets

Pros and cons of hedging

Popular hedging strategies

There are several methods that can be used to hedge, but some can be extremely complicated. That’s why we’ve taken a look at some of the most widely used ways of hedging against risk – whether this is a specific strategy, a platform function or an asset class that’s considered a hedge. These strategies are:

1. Direct hedging
2. Pairs trading
3. Trading safe havens
4. Portfolio diversification hedging
5. Index hedging
6. Options hedging

Direct hedging

A direct hedge is the strategy of opening two directionally opposing positions on the same asset, at the same time. So, if you already have a long position, you would also take a short position on the same asset.

The advantage of using a direct hedge, rather than closing your position and re-entering at a better price, is that your trade remains on the market. Once the negative price movement is over, you can close your direct hedge.

Let’s say that you have a short position on the FTSE 100, but you believe that the index is going to see a short-term rise in price as a result of a number of constituents releasing positive earnings announcements. In such an instance, you might decide to open a buy position on the FTSE to minimise your losses.

Normally, these two positions would net off, meaning that the first would be closed, but some trading platforms have a function that enables traders to hedge directly.

Pairs trading

Pairs trading is a hedging strategy that involves taking two positions. One on an asset that is increasing in price and one on an asset that is decreasing in price. Pairs trading creates an immediate hedge because one trade automatically mitigates the risk of the other trade.

The method involves finding two opportunities that are almost identical but are currently trading at irregular prices – one is undervalued, while the other is overvalued – then taking advantage of the moves toward the assets’ fair values. This strategy can be used to trade indices, forex and commodities, as long as there is a correlation between the assets in question.

If you wanted to choose two stocks to pairs trade, you’d likely look for two companies that are within the same industry, have similar financials and historical trading ranges. This strategy is not necessarily dependent on the direction that either trade will move in, but on the relationship between the two assets. It is considered a ‘market-neutral’ strategy, as it takes both a long and short position.

Trading safe havens

Safe-haven assets are financial instruments that tend to retain their value, or even increase in price, during periods of economic downturn. There are a range of assets that fall into the categories of both safe havens and hedges, such as gold.

Gold is considered a safe haven, as it has historically been investors’ go-to asset during times of financial crisis, but it is also considered a hedge against a drop in the US dollar. As the currency falls, it causes the cost of goods imported from the US to increase in price – this often results in many traders and investors using the safe haven as a hedge against this inflation.

Not all safe havens will be good assets for a hedging strategy, so it is important to do your research. But if you can use these well-known correlations to your advantage, they could offset your risk.

Portfolio diversification hedging

Portfolio diversification hedging involves spreading your capital across different sectors and asset classes to reduce overall portfolio risk. This strategy is popular because different assets often react differently to market events – when some positions decrease in value, others might increase or remain stable.

While not considered a pure hedging strategy, diversification naturally provides protection against sector-specific risks. By holding positions across multiple sectors and asset types, you can potentially offset losses in one area with gains in another.

For example, if you hold mainly technology stocks, you might diversify by adding positions in traditionally defensive sectors like consumer staples or utilities companies. If tech stocks face a downturn, these defensive positions might help stabilise your portfolio due to their typically lower correlation with tech sector performance.

Index hedging

Index hedging is a strategy that involves taking positions in indices to protect against broader market movements while maintaining exposure to individual stocks. This approach is particularly useful if you hold multiple stocks within a specific index but want protection against general market decline.

This strategy works by letting you maintain your stock positions while using index-based instruments to hedge against market-wide risks. The hedge doesn't protect against company-specific risks but helps offset losses from general market downturns.

For example, if you own several FTSE 100 stocks and are concerned about a potential market decline, you might take a short position on a FTSE 100 ETF. If the market falls, gains from your short position could help offset losses in your stock holdings.

Options hedging

Options hedging involves using options contracts to protect existing positions against adverse price movements. While more complex than direct hedging, options provide flexible protection with known maximum costs.

The main advantage of options hedging is that your maximum potential loss is limited to the premium you pay for the option. This gives you a clear view of your risk while maintaining potential for profit if markets move favourably.

For example, if you hold shares in a company, you might buy put options on those same shares. If the share price falls below your option's strike price, the put option's value increases, helping to offset losses in your share position. If the shares rise instead, you only lose the premium paid for the option.

What are the different ways to hedge?

Hedging can be carried out using a variety of financial instruments, such as CFDs, options and futures .

CFDs

There are a range of benefits of CFDs that make them suitable for hedging. Perhaps the largest advantage is that they don’t require you to own the underlying asset to open a position, which means that you can trade on both rising and falling markets. This is extremely useful when hedging because, to neutralise market exposure, you need to be able to take positions in both directions.

Options

Options are one of the most widely used hedging tools due to their flexibility and the variety of strategies available. With options, buyers gain the right, but not the obligation, to buy (calls) or sell (puts) an asset at a specified price within a set time period. Sellers, on the other hand, are obligated to fulfil the contract if the buyer exercises their right.

Key options strategies for hedging include:

• Buying put options to seek protection against potential downside in existing long positions
• Selling covered calls to potentially generate income from existing shareholdings while accepting limited upside
• Using collar strategies (buying puts while selling calls) to attempt to offset hedging costs

For example, if you hold $10,000 in shares, you might consider buying put options at 90% of the current share price. While this requires paying a premium upfront, it can help manage downside risk. However, if the shares rise or remain stable, the premium paid for the options would reduce your overall returns.

Futures

Futures provide a more direct way to hedge by locking in prices for future transactions. They're particularly useful for protecting against price changes in commodities or currencies. For example, a UK company expecting to pay $1 million for US goods in three months might use futures to lock in today's exchange rate, protecting against pound sterling weakness.

Inverse ETFs

These funds are designed to move in the opposite direction to a market or sector, making them a straightforward hedging tool. Eg if you're worried about a FTSE 100 decline but don't want to sell your shares, an inverse FTSE 100 ETF would rise when the market falls, helping offset your losses.

Once you’ve decided which way you’d like to hedge, there are two ways to start – depending on your level of confidence and expertise:

• Open a live account with us
• Test your hedging strategies in a risk-free environment with our demo account
• If you want to learn more first, you can join IG Academy to discover the financial markets, trading products and more.

How to hedge (with examples)

• Creating an effective hedging strategy begins with careful risk identification. Start by assessing your specific market exposure, determining which positions need protection, and considering both your timeframe and current market conditions. This initial analysis helps quantify the potential losses you want to manage
  
• Once you understand your risk exposure, you can evaluate suitable hedging strategies. Compare different instruments like CFDs, options etc – analysing how they correlate with your existing positions. Consider both the costs and complexity of each approach, ensuring your chosen strategy aligns with your experience level
• The next crucial step is calculating your hedge ratio. This involves deciding how much of your position to hedge – you might opt for partial hedging to balance protection with opportunity. Remember to factor in any currency exposure
• Implementation requires careful execution. For larger positions, consider phasing in your hedge gradually. Ensure you have adequate margin or capital available and document both your strategy and rationale. Setting appropriate stop-losses adds an extra layer of risk management
• Successful hedging doesn't end with implementation. Regular monitoring is essential to track your hedge's effectiveness and watch for changing correlations between positions. Keep an eye on ongoing costs and be prepared to adjust your positions as market conditions evolve

Here are some examples:

A portfolio manager with $50,000 in FTSE 100 shares might hedge against a potential market downturn by selling FTSE 100 futures contracts covering 80% of the portfolio value. If the market falls 10%, gains from the futures position would help offset losses in the share portfolio.

For currency risk, consider an investor with $100,000 in US stocks. They might protect against GBP/USD fluctuations using a forward contract to lock in current exchange rates.

In sector-specific hedging, someone heavily exposed to UK banking shares might buy put options on a financial sector ETF to cover 50% of their position value. To manage costs, they might sell covered calls to offset the put option premiums.

Remember, since hedging involves costs from opening new positions, it should only be used when the risk reduction justifies the expense. Available capital is crucial, as additional positions require margin or funds. The appropriate hedge size varies from person to person, depending on their resources and risk tolerance.