There are several effective hedging strategies to reduce market risk, depending on the asset or portfolio of assets being hedged. Three popular ones are portfolio construction, options, and volatility indicators.
Key Takeaways
Market risk, or systematic risk, is the possibility that an investor will see huge losses as a result of factors that impact the overall financial markets, as opposed to just one specific security.
Modern Portfolio Theory is one of the tools for reducing market risk, in that it allows investors to use diversification strategies to limit volatility.
Another hedging strategy is the use of options, which allow investors to protect against the risk of big losses.
Investors can also make trades based on market volatility by tracking the volatility index indicator, the VIX, often referred to as the "fear index," due to its tendency to spike during periods of greater volatility.
One of the main tools is themodern portfolio theory (MPT), which uses diversification to create groups of assets that reduce volatility. MPT uses statistical measures to determine an efficient frontier for an expected amount of return for a defined amount of risk. The theory examines the correlation between different assets, as well as the volatility of assets, to create an optimal portfolio.
Many financial institutions have used MPT in their risk management practices. The efficient frontier is a curved linear relationship between risk and return. Investors will have different risk tolerances, and MPT can assist in choosing a portfolio for that particular investor.
Options are another powerful tool. Investors seeking to hedge an individual stock with reasonable liquidity can often buy put options to protect against the risk of a downside move. Puts gain value as the price of the underlying security goes down.
The main drawback of this approach is the premium amount to purchase the put options. Bought options are subject to time decayand lose value as they move toward expiration. Vertical put spreads can reduce the premium amounts spent, but they limit the amount of protection. This strategy only protects an individual stock, and investors with diversified holdings cannot afford to hedge each position.
Investors who want to hedge a larger, diversified portfolio of stocks can use index options. Index options track larger stock market indexes, such as the S&P 500 and Nasdaq. These broad-based indexes cover many sectors and are good measures of the overall economy.Stocks have a tendency to be correlated; they generally move in the same direction, especially during times of higher volatility.
Investors can hedge with put options on the indexes to minimize their risk. Bear put spreads are a possible strategy to minimize risk. Although this protection still costs the investor money, index put options protect a larger number of sectors and companies.
Volatility Index Indicator
Investors can also hedge using the volatility index (VIX) indicator. The VIX measures the implied volatility of at-the-moneycalls and puts on the S&P 500 index. It is often called the fear gauge, as the VIX rises during periods of increased volatility. Generally, a level below 20 indicates low volatility, while a level of 30 is very volatile. There are exchange-traded funds (ETFs) that track the VIX. Investors can use ETF shares or options to go long on the VIX as a volatility-specific hedge.
Of course, while these tools are certainly powerful, they cannot reduce all market risk.
Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circ*mstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal.
As a rule, long-term put options with a low strike price provide the best hedging value. This is because their cost per market day can be very low. Although they are initially expensive, they are useful for long-term investments.
Delta hedging is commonly utilized in managing equity and options portfolios, ensuring risk is minimized. For instance, investment banks employ delta hedging to manage the risk associated with their options trading desks.
Hedging is a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset. The reduction in risk provided by hedging also typically results in a reduction in potential profits. Hedging requires one to pay money for the protection it provides, known as the premium.
We refer to a “perfect” hedge when there is a 1:1 correlation between the financial and physical markets. Example 1: Assume the price has gone down.On November 1st the spot market prices are $59.3/bbl and in that case (assuming perfect hedge) the December futures contract would be $60.30/bbl.
For a hedging relationship to be highly effective, the changes in value attributed to the hedged risk should offset the changes in value of the hedge within stated limits. Practice has dictated that highly effective is defined as 80% to 125% effective.
Pairs trading: taking two positions on assets with a positive correlation. Trading safe haven assets: gold, government bonds and currencies such as the USD and CHF. Asset allocation: diversifying your trading portfolio with various asset classes.
Short a market index: Investors can hedge their market exposure by shorting an exchange-traded fund (ETF). For example, shorting the popular SPDR S&P 500 ETF (SPY 0.14%) would enable an investor to hedge against a decline in the S&P 500 index.
The hedge only protects against adverse movements in the relative value of the U.S. dollar as expressed in the U.S. dollar price of gold. By holding long gold futures contracts, investors stand to gain when the U.S. dollar loses value as expressed by gold.
The primary reason for hedging is risk management: attempting to mitigate the extent of potential losses. Rather than closing an existing trade that could move in an undesirable direction, choosing to hedge (e.g., take the offsetting position in an asset) may mitigate potential losses.
Diversification is more effective in mitigating unsystematic risk, known as specific or idiosyncratic risk. This type of risk is specific to individual assets or companies and can be reduced by spreading investments across different assets with varying risk profiles.
Hedging is an advanced risk management strategy that involves buying or selling an investment to potentially help reduce the risk of loss of an existing position.
Portfolio diversification is the process of selecting a variety of investments within each asset class, which can help those looking to reduce their investment risk.
Learn about hedging and explore the three main types of hedging transactions in foreign operations: Cash flow hedges, fair value hedges, and net investment hedges.
Hedging is the practice of opening multiple positions at the same time in order to protect your portfolio from volatility or uncertainty within the financial markets. This involves offsetting losses on one position with gains from the other.
For example, a businessman buys stocks from a hotel, a private hospital, and a chain of malls. If the tourism industry where the hotel operates is impacted by a negative event, the other investments won't be affected because they are not related.
Introduction: My name is Barbera Armstrong, I am a lovely, delightful, cooperative, funny, enchanting, vivacious, tender person who loves writing and wants to share my knowledge and understanding with you.
We notice you're using an ad blocker
Without advertising income, we can't keep making this site awesome for you.
:max_bytes(150000):strip_icc()/GettyImages-1735541580-b962ad2ee68a4fd992c285913842971b.jpg "The Most Effective Hedging Strategies to Reduce Market Risk (1)")
