Hedging in trading involves using different instruments and strategies to offset the risk of negative price movements on your open positions. Discover different hedging strategies and how to hedge with CFDs.
- What is hedging?
- Why is hedging important?
- Six hedging strategies
- Disadvantages of hedging
- How to hedge a trade
- Hedging FAQs
What is hedging?
Hedging is a method of trading that seeks to reduce risk in by opening one or more positions that will balance an existing trade. While hedging doesn’t prevent risk completely, it can limit losses to a known amount.
Normally, the new position(s) would be in a market that has a negative relationship to an open trade, on the same market in the other direction – known as a direct hedge – or using an instrument that enables you to trade on future prices
Why is hedging important?
Hedging is important to understand as large companies and investment firms hedge. Having a basic grasp of the process can help you to analyse their actions and implement your own strategy.
For individual traders and investors, hedging might never be a concern. A lot of long-term investors won’t necessarily worry about the impact of short-term declines in their assets, focusing on the longer-term trend instead.
However, some investors view hedging as an opportunity to limit the impact of losses and protect an investment portfolio from adverse movements.
Performing a hedge is commonly compared to taking out insurance, in that you’d be paying an additional cost to protect yourself against a potentially negative event. If the event does occur, you’d have limited your losses and if the event doesn’t happen, your profit would be capped as you’d have the cost of the ‘insurance’ to pay out of your earnings.
Six hedging strategies
Hedging strategies typically involve the use of derivatives – products that take their price from the underlying market but do not involve the buying and selling of the asset in question.
Beyond the instrument used to hedge, you could build a strategy around your asset allocation, finding markets that move in the opposite direction from each other.
Common hedging strategies include:
- Trading CFDs
- Trading futures
- Trading options
- Trading safe-haven assets
- Trading pairs
Let’s take a look at these popular hedging strategies and some examples.
1. CFD hedging strategy
CFDs are a very popular hedging instrument due to the fact you can offset any losses against profits for tax purposes.1 But there are a lot of other benefits to the product too, such as:
- They have no expiry date, making them perfect for longer-term protection
- They’re leveraged, meaning you can open a position with just a small initial deposit. While leverage can magnify profits, it can also magnify losses – making a risk management strategy necessary
- They can be used to trade rising and falling markets, enabling you to hedge an existing long position with a short position
- They mirror the underlying market directly, so you’ll always know the relationship between your hedge and existing trade
- The position size can be easily altered to replicate your existing trade, other hedging tools often have standardised sizes that can make this more difficult
CFD hedging example
Say you owned 500 shares of Apple. While you believe in the company over the longer term, you think some negative news is going to cause a decline in the short term. You could just let the market run its course, and your shares might decline and then rise. Or you could perform a short hedge with CFDs.
Let’s say you open a ‘sell’ position on 500 Apple CFDs, giving yourself the same exposure as your existing trade. Given that CFDs are leveraged, you’d only have to pay a small deposit, rather than the full exposure.
If the price of Apple shares did fall, you could close your trade and take the profit. You’d hope that these earnings at least mitigated some of the loss to your investment position.
However, if the price of Apple shares increased instead, you’d make a loss on your stock CFD position. This would eat into the profits your investment position would’ve earned you.
It’s also important to consider the other costs of CFD trading. For example, on this shares trade, you’d have to pay a commission for opening and closing the position.
2. Futures hedging strategy
Futures contracts are another common choice for hedging, normally used by production companies to secure a price for their commodity product. They enable you to lock in a price for a future date.
While companies will be looking to exchange the physical good, futures can also be settled in cash – which means futures can also be used for speculation.
Futures hedging example
In another example, a corn farmer is due to harvest their crop in three months. In the interim period, the farmer is open to the risk that the price of corn will fall.
To mitigate this risk, the farmer sells a three-month futures contract at the current market price of $7 per bushel. This would be a forward hedge.
In the three months that pass, the market price falls to $5 per bushel. The farmer can sell the corn at the new market price and buy back the short future which would’ve earned a $2 profit.
Instead of only earning a $5 per bushel profit, the farmer would now be earning the full $7 that they would’ve received three months before.
If in the three months, the price of corn had risen instead – say to $10 – the farmer would sell the crop at that price. The futures contract would’ve made a $3 loss, meaning the total profit would still be $7 per bushel.
As we can see, hedging effectively worked in limiting the losses that would’ve been incurred, but it did also cap the total profit that could be earned.
3. Options hedging strategy
An options contract gives the holder the right, but not the obligation, to buy or sell an asset before a specific expiry date, at a set price. It’s a popular hedging instrument as buying an option is limited risk – you’ll only pay the premium that it costs to open the position.
This means that your hedge can only ever eat into your profit by so much, as you can allow your position to expire worthless if the market doesn’t move as expected.
Options hedging example
Let’s say you are long shares of Tesla, but you think the price is going to fall in the short term. You don’t want to close your position but want to offset the loss you’d incur. So, you decide to buy a put option – an option to sell your shares at a specific price on a future date – to protect your position.
You’d be able to lock in the current market price, and if Tesla shares did fall in value, you could sell them for more than the new lower price. You would pay a premium to do so.
If the price of Tesla shares rose instead, your put option could be left to expire worthless, and you’d only have lost the premium you paid to open the option position. The profit to your investment would likely offset this payment.
4. Trading safe-haven assets
Safe-haven assets are instruments that are expected to retain or even increase when there’s broad market instability. Common examples are gold, the Swiss Franc and government bonds.
Traders can hedge against market declines and limit losses from ‘riskier’ asset classes by going long on a safe haven.
For example, gold is commonly used as a hedge against inflation, because its value remains relatively constant while prices rise. Going long on gold is also a common hedging strategy for stock market crashes, as it typically has an inverse relationship with most industries.
5. Pairs hedging strategy
Pairs trading is a way of hedging via positive correlations. It involves matching a long position with a short position on two highly correlated stocks.
Finding these correlations between shares requires traders to look at historical data to identify typically correlated stocks that have deviated from each other – so that one asset is overvalued and one is undervalued.
The trader would then go long on the stock that is undervalued, and short on the stock that’s overvalued. Over time, the theory is that the assets should revert to their original positive correlation.
Diversification is the idea of opening multiple positions across different sectors, asset classes and geographies as a way of spreading risk out. It’s the trading version of ‘don’t put all your eggs in one basket’.
The allocation of your assets would determine how effectively this hedging strategy works. For example, if you had 90% of your capital in stocks and only 10% in forex, the risk is still highly concentrated.
One of the most common ways of diversifying is through indices and funds, which both provide exposure to multiple assets through a single trade.
Disadvantages of hedging
The main disadvantage of hedging is that it is an additional cost to you, over and above the position you already have. But if you’re employing a hedging strategy, it’s because you want to minimise your risk, not because you want to profit.
It’s also important to remember that the perfect hedge is extremely difficult to achieve. Your hedge will likely not exactly net off your existing trade but come in slightly above or below it in terms of profit or loss.
How to hedge a trade
To start hedging trades, you’ll need to:
- Open an account, or log in to an existing account
- Choose whether you want to hedge via CFDs, futures or options
- Consider how much you can afford to pay, and the costs of trading
- Build a risk management strategy, including attaching stops and limits
If you don’t feel confident to trade live markets yet, you could build your hedging strategy in risk-free demo account.
What are the best currency hedging strategies?
The most common currency hedging strategies are direct hedges and correlations. With a direct hedge, you’re taking the exact opposite position – if you were long AUD/USD, you’d open a short position. With a correlation FX hedging strategy, you’re looking to find pairs that move in the opposite direction to each other.
Can you use a CFD to hedge?
Yes, CFDs are a popular hedge given they can be used to go long and short on markets, and are cost-efficient for short-term trades given they’re leveraged, so you’re only required to pay a small initial deposit to open a position.
However, leverage does come with significant risks to be aware of – including the potential to lose more than your initial deposit. You can manage CFD risks with stops and limits.
How do you hedge your portfolio?
You can hedge your portfolio with derivative products, such as CFDs, futures and options. These enable you to short-sell assets without having to borrow the underlying from a third party because you’ll just be speculating on the market price.
Learn about CFDs vs stock trading