Candlestick Trading Blog
March 4, 2008
Hedging
Hedging is one of many investment strategies designed to minimize exposure to an unwanted business or investment risk, while still allowing the business to profit from an investment activity. In financial terms, a hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment. The best way to think about it is to think about it as insurance however, it is important to note, that insurance is a lot more precise. When an investor decides to hedge, he or she is protecting themselves from a negative event. They cannot prevent the negative event from happening but what they can do, using this technique, is reduce the impact of the event. A very easy example of this is home owner’s insurance, or flood insurance, and of course hedge fund investing. Hedging techniques may involve the use of complicated financial instruments such as derivatives. The two most common derivatives include options trading and futures trading. When using one of these derivates, you can develop a trading system where a loss in one investment is offset by a gain in another. A company may also depend on commodities when hedging especially if the issue is the volatility of the price of a specific commodity. An investor may enter into a futures contract in order to protect themselves in the event that price were to increase drastically. Through the purchase of the futures contract, the company can now buy the commodity at a set price at a set date in the future, without the fear of a drastic price increase. Portfolio managers, corporations, and individual investors use hedging as a method to reduce their exposure to various risks. In fact, there are so many different types of options and futures contracts that investors can hedge against almost anything. Anything could include a stock, commodity price, interest rate, currency, etc. The downside is that it has a cost. It is important to remember this and also to remember that the point is not to make money, but to protect ourselves from potential losses. Another method of hedging includes the use of hedge funds. Hedge funds pool investors’ money together and invest those funds in a financial instrument in efforts to make a positive return. A fund of hedge funds is an investment company that invests in a hedge fund rather than investing in individual securities. Some funds register their securities with the SEC. These types of funds must provide investors with a prospectus and must file certain reports quarterly with the SEC. Hedge fund investing is very similar to mutual fund investing except that not all hedge funds are required to register with the SEC. They are however, subject to the same prohibitions against fraud just like other market participants, and their managers have the same fiduciary duties as other investment advisors. There are again, a lot of different ways to hedge. With options markets, most involve the speculation of price direction of an underlying asset, while taking advantage of the leverage, cost and timing characteristics of options. Just like all other investment strategies that you decide to take one, make sure that you understand the ins and outs of this type of risk management before you begin. Pick up the March 2008 issue of Stocks and Commodities Magazine to read Steve's article 'The Candlestick Kicker' in the Technical Analysis section. Online Stock Market Reviews presented live via the internet by Stephen Bigalow |
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