While the stock market’s optimistic bull run feels exhilarating, it comes with a certain fear of correction. The market euphoria can prove to be just as costly as it is thrilling. This is where hedging strategies come in. They offer tools for cautious investors through a bull run and help in mitigating potential risks. In this blog, we will have a look at some of these strategies.
Why is hedging important?
While bull runs present exciting opportunities, they also harbour hidden dangers. Unforeseen events, like economic downturns or interest rate hikes, can trigger sudden corrections, wiping out substantial gains. Here is what can happen if you hedge your risks.
- Protect capital: Limit potential losses if the market turns against you, preserving your hard-earned gains.
- Reduce portfolio volatility: Smooth out the ups and downs of the market, ensuring your portfolio doesn't mirror every swing.
- Lock in profits: Secure a portion of your gains, especially when nearing your investment goals, preventing their erosion in case of a downturn.
How to hedge your risks?
A diverse toolbox of hedging strategies exists, allowing you to tailor your approach based on your risk tolerance and investment goals. Here are some popular options.
- Put options: Grant the right, but not the obligation, to sell a stock at a predetermined price (strike price) by a specific date (expiration date). If the market falls below the strike price, you can exercise the option to sell at a higher price, locking in a profit or offsetting losses.
- Short selling: Borrowing shares from your broker, selling them immediately, and repurchasing them later to return to the lender. If the stock price falls, you repurchase at a lower price, pocketing the difference. This strategy carries significant risk and should only be attempted by experienced investors.
- Inverse ETFs: Track an underlying index inversely, meaning they rise in value when the index falls. Holding them alongside your long positions can provide a buffer against market downturns.
- Stop-loss orders: Automatically sell a holding if the price falls below a predetermined level, limiting potential losses. While not strictly a hedging strategy, it plays a crucial role in risk management.
How to choose the right hedge?
Each hedging strategy has its own advantages and disadvantages. Selecting the right one depends on these factors.
- Risk tolerance: Are you comfortable with potentially higher returns alongside increased risk, or do you prioritize capital preservation even with lower potential gains?
- Investment horizon: Short-term strategies like options might be suitable for near-term protection, while long-term investors may prefer less active hedges like inverse ETFs.
- Underlying assets: Not all strategies apply to all asset classes. Research the available options for your specific investments.
Beyond the basics
While this blog provides an overview, advanced hedging strategies exist, catering to experienced investors.
- Spreads: Combining multiple options contracts (puts and calls) to create customized risk-return profiles.
- Hedging with futures: Locking in future prices for commodities or currencies to protect against price fluctuations.
Remember: Hedging is not a foolproof guarantee against losses. It involves costs and can impact your overall returns.
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