Hedging Strategies to Reduce Market Risk

Events like geopolitical conflicts, industry crises or a pandemic lead to sudden changes in the financial markets. These events are often unpredictable, and the associated risks cannot be completely eliminated, irrespective of whether you are a beginner trader or a veteran with years of experience. All you can do to protect your portfolio is minimise the impact of a catastrophic market event. Enriching your trading strategies with hedging techniques can be an effective way to preserve your portfolio’s value. 

I Manage My Risk. Is Hedging Still Important?

Good question. Yes, you do, and here’s why:

George Soros, popularly called the “man who broke the Bank of England,” lost nearly $1 billion in 2017 due to his bearish position during the market rally after Donald Trump’s surprise victory in the 2016 US presidential election. Do you think someone with his level of experience would have failed to manage the risks associated with his position? Market risks have a broader impact on a sector, such as the dotcom bubble. Losses may be inevitable, sometimes across sectors, such as due to the pandemic-led shutdowns, which only benefitted the logistics and pharma industries.

However, you will be surprised to know that despite the massive loss, Soros’ firm reported profits before and after the US presidential election because of the positions held in certain sectors. That is precisely what hedging is. It enables you to reduce the risk associated with one position with other positions in unrelated or negatively correlated assets. In other words, hedging allows you to compensate for the underperformance of one asset with the overperformance of another.

More reasons to employ hedging:

• Minimising the tax implications associated with selling a position.
• Reducing the risks of a portfolio overconcentrated on a certain asset class, such as growth stocks.

Caution: Hedge optimally relative to your risk appetite. Overhedging may neutralise your profitable trades and lower total gains. Underhedging, on the other hand, may not sufficiently mitigate the risks.

Most Popular Hedging Strategies

Here are the commonly used hedging strategies expert traders include in their trading strategies:

Diversification

Diversification is a key concept in the Modern Portfolio Theory (MPT). Diversification entails building a portfolio with exposure to a variety of asset classes. These assets are usually negatively correlated or uncorrelated.

For instance, you are trading forex and take a long position on the USD/EUR. Now, you understand that the US dollar and gold tend to be negatively correlated, and that gold is a safe haven asset that protects you against broader market uncertainties. Therefore, you take a long position on gold as well. 

The essence of diversification is to group assets in a manner that helps reduce overall portfolio volatility. You use statistical measures to identify the most suitable investment vehicles to maximise chances of generating the desired returns for a defined amount of risk.

Two crucial market risk parametres to know here are:

1. Beta Coefficient: This measures the volatility of your chosen instrument relative to the overall market. It helps you determine whether the instrument of your choice is moving in line with the market.
2. Value at Risk (VaR): This is a measure of potential value over a certain timeframe associated with your positions. It includes calculating the size of potential loss, its probability of occurrence, and the point in time when it may occur.

The two metrics give you a clear picture of risk exposure to determine the results to aim for. You must consider these while creating trading strategies. Many traders use high-risk instruments to capture outsized gains. However, you must remember that the risk taken must be within your tolerance limits.

Using Derivative Instruments

Derivative instruments allow you to take positions in rising as well as falling markets. Contracts for Difference (CFDs) are among the most popular hedging instruments. Here’s what a trading strategy with CFDs looks like:

• Choose an asset to trade. You must understand the market and the factors that move it.
• Take a larger-sized position in the direction you expect the asset to move.
• Take a smaller position in the opposite direction to hedge against the risk of your position.

Now, even if the market moves against your speculated direction, your stop loss threshold will limit the losses incurred. Additionally, the gains from your hedging position will offset the loss.

Trading via CFDs offers the advantage of using leverage. This amplifies your purchasing power. However, you must exercise caution since it also magnifies potential gains and losses proportionally. Therefore, CFD trading strategies must include thorough risk analysis and stringent risk management techniques.

Pairs Trading

This hedging technique trades two positively correlated assets. These may not necessarily belong to the same class. Pairs trading is also known as a long-short trading strategy.

Popularly, traders use a pair of positively correlated assets, one of which is overvalued and the other undervalued. Experienced traders identify a positively correlated pair and search for opportunities when their prices are expected to move in different directions. The deviation between their pricing creates an opportunity to take opposing positions in both assets. Statistical methods can be used to determine associated risks and profit potential of the opportunity.

Note that a momentary spike or drop in one asset’s price is not enough. There should be an identifiable trend that is ripe for reversal. Then a long position can be opened on the undervalued asset and a short one on the overvalued asset. As the market corrects itself, the prices of both assets will approach their actual values, re-establishing the positive correlation and generating positive returns.

Remember to practice such strategies on a demo account to back-test and master them before applying them on the live markets.

To Sum Up

• Hedging is a popular technique to mitigate market risks.
• Hedging strategies are different from employing risk management techniques.
• Portfolio diversification, pairs trading, and using CFDs are popular hedging strategies.

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