A Beginner’s Guide To Financial Hedging Strategies

Although it is a hard task for an individual with no prior knowledge or experience to break into the world of investing, with modern technology there are increasing options for this to become a possibility.

In fact, there are now many apps and services which automate much of the investing process, making it accessible to anyone. Most of these apps, Moneybox, for example, use a form of investing known as hedging. Hedging is a financial strategy that any budding investor should understand. There is a reason that the aforementioned app, and others like it, have gone for a hedging model: it is a safer way of investing.

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What is hedging?

It is probably easiest to think of hedging as a type of insurance. By hedging, investors are creating a sort of insurance against any losses in one area. They do this by spreading their investment over many different areas. The apps and other automated services will split user’s investments amongst property, cash, and assets, for example. The gains are modest and slow, and yet these services can truthfully guarantee their users that they have a high probability of earning a return on their investments.

For the average person who is using an app or service to handle investments for them, their goal is convenience and ease. In other words, they aren’t looking to actually learn about the intricacies of investment and take it up themselves. If you are looking to make serious returns, however, then you need to step outside of this comfort zone.

For those who are managing their investments themselves, you should look for two assets which have a negative correlation. This means that when one goes up, the other goes down. They do not have to be directly causally linked (meaning that one asset going up causes the other to drop in value), but only need to be correlated.

How do investors hedge?

Usually, when investors hedge, they take advantage of something called a derivative. A derivative is a type of security. The value of the derivative is determined (or derived) by the value of one or more assets, which are defined in the contract. A derivatives contract sets out the terms by two parties whereby the value of the security is related to the value of the underlying asset. These underlying assets can come in just about any form. The most common types of derivative used are options and futures.

Options are a contract between two parties whereby one party the right to buy or sell a nominated asset at a set price, during a specified time period. Note that while they have the option of buying the asset, there is no obligation to do so.

By comparison, a futures contract pledges to sell or buy a particular asset at a future date. Futures are most commonly used on assets like crude oil. They are considered riskier than simply watching the market and betting as you go, but they are popular throughout the investment world.

Check out this guide, currency hedging products explained, to get a better idea of the different forms of hedging.

Before you proceed

There are some things that you should bear in mind if you are considering hedging. It may be a safer investment strategy in the eyes of many, but no investment is without risk. As with any investment, you need to carefully weigh the terms and consider whether the likely, and potential, benefits outweigh the risk that you are taking. If you are in any doubt here, then make sure that you don’t rush into the decision.

While the insurance analogy clarifies hedging, it should be noted that hedging is not as precise as insurance, nor does it offer the same guarantees. There is an inevitable cost to hedging, and if things go in opposite direction to the one you are hoping for, then you will find yourself losing money on the deal.

FG Editorial Team
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