Even if you’re a complete novice when it comes to trading, it’s probable that you’ve at least heard the word “hedging” before. It comes up in all sorts of non-financial contexts, including the idiom “hedging your bets.” And it means something remarkably similar in the financial world, too: it refers to the practice of taking out a second open position in an attempt to “offset” potential losses that the first might cause. This article will delve into further detail about what hedging is and why a trader might want to make the most of it.
What is hedging?
In short, hedging is a way of managing the risk involved in placing trades of a financial instrument. Hedging relies on “offsetting”: if a trader believes that one of their open positions might be vulnerable to a decline in value, a hedging trade can be set up that will benefit if that decline materialises. In short, it’s a way of covering as many bases as possible and having profitable investments open no matter what.
Why would you use it?
Risk is built into the financial system, and it exists at all levels. Even someone who never traded would be running a risk of cash depreciation thanks to inflation. Risk is inescapable, and the purpose of a hedge is to manage the risk of trading to one extent or another. Hedging is not free, of course, but if the cost of setting up the hedge is lower than the amount saved if the original trade goes wrong, it can pay off. Hedges are often used in foreign exchange markets because those markets are relatively volatile. They’re also often used for high-value trades, given the more intense consequences if the trade goes wrong.
Is hedging safe?
When it comes to safety, some new traders mistake the practice of hedging as a way of making a trade failsafe. But that’s not the case at all. Hedging is no guarantee against losses. Traders who are thinking of hedging ought to make sure they know exactly what they’re doing and should have a broader strategy in place that suits their asset class. And hedging is no substitute for due diligence and research either: traders should still stick to best practice, such as reading The Bull share tips or checking out broker reviews.
As is the case with the vast majority of trading strategies, there’s no clear answer as to whether or not they’re suitable for a newbie trader. Instead, it depends on several factors – including the market being traded, the amount being staked, and more. Hedging can be helpful in all sorts of circumstances, such as the market in question or the size of the trade – but it’s not a foolproof practice and is instead best understood as a way for investors to manage their risk. By doing some more reading around the topic, a trader can ensure they know what they are letting themselves in for.