There are different ways to hedge stock market investments. There are also a number of strategies that are used in all these types to ensure proper hedging of securities.
Hedging does a lot of amazing things for not just the investor but also the stock market itself. As a risk measure, it limits the losses of the investors in unfavorable market conditions and protects the potential profits of the investor.
In other words, the goal is to curb the losses that may arise due to unknown fluctuations in the investment prices and to lock the profits therein. For the stock market itself, it increases the liquidity of the financial markets.
This is because various hedging prompts are used by the investor to trade across different markets. Particularly, the investor can relax knowing that his investments are at a safe average even when things go down.
An investor has options with many areas available to hedging like securities, currencies, interest rates as well as commodities and agricultural products.
There are different ways to hedge stock market investments. There are also a number of strategies that are used in all these types to ensure proper hedging of securities to minimize the exposure to various types of risks and decrease the negative impact. They include:
Types of Hedging Tools
There are broadly three types of hedges used in the stock market. They are: Forward contracts, Future contracts, and Money Markets.
FORWARDS
Forwards are non-standardized agreements or contracts to buy or sell specific assets between two independent parties at an agreed price and a specified date. It covers the contract of various assets including forwarding exchange contracts for currencies, commodities, etc.
They are particularly used to hedge currency transaction exposures because of the volatility of foreign exchange currencies. It is also great for commodities. For example, if a farmer plants a crop and expects the crop to make him gain 500,000 Naira in 3 months when it is harvested, he finds a buyer who is willing to purchase his crops at that exact price in 3 months.
That way, even if the value of his crops drop to when it would yield only 300,000, he is secured because the price is locked. However, if the crops can yield 700,000, he would lose all the extra profit.
FUTURES
Futures or a Futures contract on the other hand is a standardized contract to buy or sell an underlying asset between two independent parties at an agreed price, standardized quantity, and a specific date.
Just like forwards, it also covers various contracts like currency futures contracts, etc. One thing to note is that future contracts may not be the best way to trade stocks, but they are a good for commodities and currencies. They have fixed upfront trading costs and most futures markets are very liquid.
MONEY MARKETS
The third hedging tool is to use is the money market. Money markets are great for the investor as they help him cover or hedge different types of financial activities of currencies, including short-term loans, borrowing, and other forms of trace that happen within a maturity of period of a minimum of a year.
Other tools include options which are contracts giving the buyer the right (permission), but not the obligation (necessity), to buy or sell an underlying asset or instrument at a specified strike price prior to or on a specified date, depending on the form of the option.
These tools help the investor secure his tomorrow for risk while also limiting him where profits are made by the hedged assets. The specific hedging strategies that are commonly used today would be highlighted in the next post.
Written by Lawretta Egba.
