Hedging: what is it and how does it work?

Hedging is a trading strategy that is often used to mitigate the risk of loss in a financial market. Simply put, hedging consists of taking an opposite position to the one you already hold in the market in order to reduce the risk of loss.

How hedging works in trading

Hedging is used to mitigate the risk of loss in a financial market. To do this, a market participant takes a position opposite to the one he already holds in the market. This opposite position is called "covering position".

The basic idea of ​​hedging is that when the price of a financial asset moves in one direction, the market participant can limit his losses by taking an opposite position so that if the price moves against his initial position , the hedging position can offset losses. In this way, the market operator can limit the risk of loss.

However, hedging does not completely eliminate the risk of loss, it only reduces it. This means that the market operator will always have to monitor the market closely to avoid incurring losses and to decide when to close the hedge position.

Types of hedging

There are different types of hedging that traders can use on the financial markets. The most common types of hedging are listed below.

Hedging with futures

Hedging with futures is a type of hedging in which a market participant takes a position in the futures market to hedge his position in the spot market. In practice, the market maker buys or sells a futures contract that corresponds to his spot market position.

Hedging with options

Options hedging is a type of hedging where a market participant buys or sells an option to hedge his position in the spot market. In practice, the market maker buys a call option if he has a long position in the spot market and a put option if he has a short position in the spot market.

Hedging with swaps

Swap hedging is a type of hedging in which two parties exchange cash flows based on an interest rate or exchange rate. In practice, a market participant can use a swap to hedge the risk of loss on his spot market position.

Hedging with CFDs

In hedging CFDs, a trader can use financial derivatives, such as Contracts for Difference, to open a position in the opposite direction to the existing position to offset potential losses in the original position, thanks to profits in the CFD short position.

How to start hedging CFDs

But how to hedge in practice with CFDs? To hedge with CFDs (Contracts for Difference), you can follow these steps:

• Login to the platform of your Broker, such as, for example, xStation
• Identify the position you want to hedge: before hedging, you need to know which position you want to hedge. For example, if you have a long position on the FTSE 100, you can hedge it with a short position on the FTSE 100 CFDs.
• Open a contrary position: once you have identified the position to cover, open a contrary position on the same underlying asset using CFDs. For example, if you are long on the FTSE 100, open a short position on the FTSE 100 CFD.
• Adjust position size: Make sure you adjust the reverse position size to balance out your total exposure. For example, if your long position on the FTSE 100 is valued at EUR 10,000, open a short position on the FTSE 100 CFD at or near EUR 10,000.
• Monitor positions: constantly monitor your positions and adapt your hedging strategy based on market trends. For example, if the price of the FTSE 100 falls and your long position suffers losses, your short position on the FTSE 100 CFD should generate profits to offset the losses.
• Close Positions: When you decide to close your original position, you must also close your CFD hedging position. Make sure you do it at the right time to maximize your profits and minimize your losses.

It is important to remember that hedging with CFDs involves a cost in terms of spreads and commissions, so make sure you take this into account when deciding to adopt this strategy. Additionally, trading CFDs carries a high risk of capital loss, so it is important to be aware of all the risks involved and to only trade with money you can afford to lose.

Considerations for using hedging in trading

While hedging can help reduce the risk of loss in trading, there are a few considerations market participants should keep in mind.

• Transaction costs: Taking a hedging position incurs additional expenses, such as commissions, spreads and interest. Market participants need to carefully consider these costs and assess whether hedging is a viable option to reduce risk.

• Effect on overall performance: Hedging can reduce the risk of loss, but it can also limit the potential for gains. When taking a hedging position, the market participant may not benefit from an increase in the price of the underlying financial asset. Therefore, market participants must balance the desire to reduce risk with the need to maximize their overall performance.

• Timing: Hedging requires constant attention to the market and an accurate decision on the right moment to take a hedging position. Market participants must carefully consider when to take a hedging position and when to exit it to avoid incurring losses.

• Overall Trading Strategy: Hedging should be considered as part of an overall trading strategy and not as an independent solution to reduce risk. Market participants should carefully consider their trading style, time horizon and risk tolerance before deciding whether to use hedging as part of their trading strategy.

Conclusions

In conclusion, hedging is a trading strategy used to reduce the risk of loss in a financial market. Market participants can use different types of hedging, such as futures hedging, options hedging, and swap hedging.

However, the use of hedging requires careful consideration of transaction costs, effect on overall performance, timing and overall trading strategy. Market traders should consider these considerations carefully before deciding whether to use hedging as part of their trading strategy.

CFDs are complex instruments and come with a significant risk of losing money rapidly due to leverage. 72-89% of retail investor accounts lose money trading CFDs. Consider whether you understand how CFDs work and whether you can afford to take this high risk of losing your money.

Original article published on Money.it Italy 2023-04-24 17:16:00. Original title: Hedging: cos’è e come funziona?