Hedging Through Derivatives: What Is It And How Is It Done? MintGenie explains

It is important to note that hedging comes at a cost, just like insurance. Investing in hedging leaves you with proportionately less money to invest in the asset that is being hedged. But still, investors do this to reduce risk.

hedging through derivatives

One of the most common methods of hedging is through derivatives. Derivatives, such as options, swaps, futures and futures contracts, move in the same direction as the underlying asset. Interestingly, the availability of an array of derivatives contracts enables investors to hedge against almost any type of investment: stocks, commodities, indices, currencies, bonds or interest rates. Derivatives are considered an effective hedge against their underlying assets.

Sometimes, investors use derivatives to build a trading strategy in which losses in investments can be offset by gains in derivatives contracts. For example, when Ms. A buys 100 shares of ABC 10 per share, she would probably hedge her investment by purchasing a ‘put’ option with a strike price of 7 expiring in six months. This will enable him to sell the shares at a reduced rate of 7 Anytime in the next six months. If he has to pay a premium of Re 1 per share for the option, then 100 would be the cost of hedging.

If the stock price rises in the next six months, she will not exercise her option, but will not exercise her option if it falls. 3 per share, she will exercise her option and sell her shares for 7 per share, incurring a loss of 300 on shares, plus 100 at a premium, which makes a total 400. But without hedging, the loss would have been much higher 1,000.

Therefore, it is worth remembering that hedging is a strategy that comes at a cost, and aims to prevent or minimize losses. Furthermore, hedging is imperfect and may not work, even though it is based on calculated risks.

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