Top 5 Hedging Techniques to Reduce Investment Risk

Hedging is ideal for investors with large concentrated stock investments, as it helps them hold positions for a longer timeframe, and thus save a lot by avoiding short term capital gain tax. Hedges are most popular among large corporations, institutional investors and portfolio managers as strategically exercising financial instruments enable them to cut down investment risks significantly. Investors must realise the purpose behind using hedging techniques and these should not be wrongly attempted to profiteer. This article will list top five hedging techniques commonly used by stock market investors, but before moving on to them, let us focus on nitty-gritty of an effective hedge.

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Simply put, investing in different stocks, whose price movement is negatively correlated, automatically creates a hedge. That’s why, hedging always cuts down possibility of returns while minimizing investment risks. Common derivative instruments such as futures and options can be used in creating hedge positions to protect invested capital from losses due to absurd price fluctuations. Diversifying stock investments across global markets, such as emerging world where liquidity keep floating from one market to another, is an effective hedging strategy.

Top Stock Hedging Techniques

Hedging Using Non-Identical Stocks (Pairing)

At times when perfect hedges are not available, for instance- puts are not traded for the stocks held in portfolio then the best way to create hedge is through short sale of a non-identical security, whose price movement correlates with the security held. This technique can be exercised by employees, who are not allowed to short their own company stocks. The main task while applying this technique is to find the right match with similar risk metrics and a high correlation in price movement. This method only works for a short time frame and there is always the risk of hedge getting acquired.

Buy and Sell Options to Minimize Risks

Derivatives in form of options are most handy yet complex hedging instruments and should not be used by layman investors. Tricky pricing aspects of options due to premium feature can only be understood through in-depth knowledge, so that an effective hedge can be put in place. Professional risk managers can do wonders using Options as hedges, but that requires skill and knowledge. Common investors can benefit from simple strategies involving Options for risk management.

• Call Options- Selling a call option against the concentrated holdings in a particular stock is a hedging technique.
• Put Options- Buying puts against existing stocks in portfolio is just like buying insurance, but remember, there is hefty premium cost.
• Combining Options- Selling a call and buying a put for the same level and same expiry makes a perfect hedge with premium cost at risk and unlimited profit possibility.

Automatic Hedging and Diversification through Exchange-Traded Funds

ETFs are ideal candidates for hedging sector specific stock holdings in different companies through a single short position. However, dealing in ETF future’s can be a riskier bet.

Short Against the Box (SATB) Still a great short term hedging technique

Once, selling SATB used to be a famous escape route for investors from capital gains tax, as this is a low cost holding technique. But nowadays after congress lifted most of its tax advantages; it is only a short term hedging option. This technique involves shorting the same stock for which hedge is required.

Protect your invested money using Stock and Index Future’s

Using future’s as hedging instrument is the most cost effective way, but there are certain daily cash flow caps and floors. Individual stock futures and index futures can be utilized to hedge some of the risk till the expiry date of the contract.

Most investors never use hedges or exercise derivates as these are difficult to understand and implement. Ideally these instruments are for money managers and high worth individuals, who often find it difficult to hedge perfectly in practice.