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
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.
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Long puts are the classic way to hedge a portfolio against market drops—but they are expensive. Short delta can protect a short premium from volatility expansion because huge volatility spikes are often accompanied by big market drops. Staying small is the most effective way to hedge a portfolio organically.
Hedging protects the profits of the investor. It increases the liquidity of the financial markets as hedging prompts the investor to trade across different markets of commodity, currencies and derivative markets. The hedging offers flexible price mechanism as it requires very less margin outlay.
Hedge effectiveness is the extent to which changes in the fair value or cash flows of the hedging instrument offset the changes in the fair value or cash flows of the hedged item.
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.
What is a good hedging example? Some common examples of hedging are using derivatives such as options or futures to mitigate losses, buying an insurance policy against property losses, etc.
Conclusion: Hedge your stock portfolio to reduce market risk
While risks can seldom be avoided completely, portfolio hedging is one way to protect a portfolio against a potential loss. Hedging stocks does come at a cost but can give investors peace of mind.
Hedging is a strategy that tries to limit risks in financial assets. It uses financial instruments or market strategies to offset the risk of any adverse price movements.
Investors can use futures contracts to hedge against future price changes in the underlying asset. For example, if an investor owns a stock and fears a drop in its value, they could sell a futures contract at the current price to lock in the current value and protect against a decline in the future.
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.
Hedging strategies are designed to reduce the impact of short-term corrections in asset prices. For example, if you wanted to hedge a long stock position, you could buy a put option or establish a collar on that stock.
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