Hedging is a form of trading insurance. It is the practice of entering a position on an asset in order to cover for any potential losses in positions on another asset. Hedging is also the action of taking a position in an asset to offset losses already incurred on another asset position.
Usually, the hedge may require sacrificing a portion of any potential profits, which is considered a better option than a total loss. Hedging is used across several industries related to finance, including international trade, FX trading, stock trading, commodity trading, and banking. The aim is usually the same: to reduce the likelihood of a potential loss or reduce the degree of an actual loss by taking another position in another asset or market.
Hedging can be called a form of trading insurance. It is the practice of entering a position on an asset in order to cover for any potential losses in positions on another asset. Hedging is also the action of taking a position in an asset to offset losses already incurred on another asset position.
Hedging as a Concept
This article will address hedging as a concept in the world of financial trading. There is always an element of risk whenever a trader takes a position on an asset. The markets are driven by news and risk events, which can work in the trader’s favor or against them. Some of these risk events could be unpredictable, unscheduled, and unexpected Black Swan events. Examples of risk scenarios in financial trading are presented below and cut across all markets and assets.
For instance,
- A long-term stock investor can face the risk of a market decline. The financial markets are still reeling from the US-Iran war, an unexpected event that has triggered unforeseen stock market declines.
- There were several bullish forecasts on gold heading into 2026. A gold trader who made a gold purchase has faced a price collapse risk due to the oil shock stemming from the US-Iran war.
- A Middle East geopolitical conflict, such as the current one between the US and Iran, has led to the closure of the Strait of Hormuz, a major shipping conduit for crude oil. An investor in aviation stocks has suffered a decline due to the expected impact of rising fuel prices on the company’s margins.
- A portfolio manager managing clients’ assets could face risks from macro-event volatility, especially when other Black Swan events come into play.
All the examples presented above indicate one thing: you can perform all your analysis, and this can all be correct. But something can always come up to change the narrative and alter market sentiment in a direction contrary to the stock purchase or the market positioning in FX, metals, or indices. The essence of hedging is to safeguard the trader’s capital against such occurrences.
A hedge is a strategy designed to offset or mitigate these risks, either partially or fully. The hedge may not eliminate all risk, but it can offer some protection in situations where 100% risk elimination is not possible.
What Makes a Good Hedge?
A good hedge must be able to satisfy the following requirements:
- It must be able to reduce risk in an efficient manner. Risk reduction with inefficiency will not cut it.
- It must preserve acceptable upside potential. The hedge must be able to bring is as much money as is possible to offset any losses.
- It should be liquid enough so the trader can easily exit the position once the hedging objectives are reached. You need to be able to get out of the hedged position quickly before it starts to suffer a reversal.
- It must be able to match the level of exposure it is designed to protect. If you are down $10,000 in a standard position, your hedge should match that level of commitment in terms of sizing.
Hedging in Trading: Important considerations
What are the things you need to consider when executing a hedging strategy?
- The degree of correlation between the initial asset invested in, and the asset used in the hedge
- The hedge cost, as this cost must not add more financial drain on the trader.
- Time frame:
- Degree of volatility
- Liquidity.
When it comes to correlations, traders sometimes use correlated assets (those that respond in a predictable way to the same triggers) to hedge. For instance, gold stocks move with gold prices, while oil stocks move in the same direction as oil prices. Similarly, we see currencies of oil exporters moving in tandem with oil prices, while currencies of oil importers move in an inverse direction to oil prices.
Example: To conduct an oil-sensitive currency hedge, a trader may decide to trade the CAD/JPY. Canada is a net exporter, and the CAD moves in the same direction as oil prices. Japan is a net oil importer, and the Yen moves in the opposite direction to oil prices. So the CAD/JPY is a good example of a hedge asset that can be used as a proxy for trading crude oil. This is an example of a cross hedge.
When it comes to cost, please understand that hedging is rarely free. The trader employing a hedge can expect to incur costs through option premiums, reduced upside potential, spreads, overnight carry costs or reduced profitability.
Real-World Hedge Examples
1. Hedging an Equities Portfolio
For an account manager who is long on stocks, a potential hedge would be to buy puts on a stock index before a Fed interest rate decision. No one can predict how a rate decision will play out; the fund manager would prefer to hedge against an equity drawdown by purchasing put options to benefit from a potential decline in index prices.
2.Commodities Hedge
An oil producer will sell oil futures to lock in higher prices and prevent losses from price declines, while an oil product consumer will buy oil futures to lock in lower prices to protect against price hikes in the future.
An airline may deploy a long hedge to protect against rising prices. If an airline knows that it will need to purchase 100,000 gallons of JetA1 fuel in three months, it can decide to long futures on oil at $90 per barrel, knowing that an increase in oil prices can cause the price of Jet A1 to spike from $6.00 a gallon to $8 a gallon. To protect against a collapse in their operating margins due to higher prices, the airline will lock in this hedge trade so that it is assured of the 100,000-gallon supply at $6 per gallon.
3.Export Hedge Against Currency Fluctuations
A Japanese exporter may decide to hedge against a weaker Yen if there is a risk of Yen weakness from rising oil prices. The exporter will ensure that futures contracts are signed to lock in a specific price, so that any exchange rate fluctuations affecting the Yen will not affect his profits.
4.Cryptocurrency Hedge
A crypto trader who holds Bitcoin and expects the price to rise from $75,000 to $100,000 per BTC will also short BTC futures during periods of macro uncertainty as a form of cryptocurrency hedging. Risk-off market scenarios cause crypto market selloffs, so that the short BTC futures position will offset any losses from the holding position (long).
5.Gold Hedge
An investor who holds equities may also decide to buy gold, which is a safe-haven asset. During times when risk-off sentiment prevails, and equities are at risk of a selloff, there is usually a flight to the safety that gold provides. The rise in gold prices can then offset any losses in the equities market.
When is Hedging Typically Used?
Traders tend to deploy hedging under certain conditions. These are:
- global economic uncertainty (e.g. a pandemic or financial contagion)
- high market volatility periods
- major event risk (such as the current US-Iran war)
- leveraged market exposure (leverage increase risk)
- For diversification in a situation where an asset portfolio is overconcentrated on one asset type or market.
Risks of Hedging
Hedging is used to mitigate risk, but it usually comes with some tradeoffs.
Reduced Profit: This is the most common compromise a hedge strategy has to make. Protecting against an originally bad trade will invariably lead to gain reduction. Similarly, if the original trade is good, the hedge will lose and this reduces profits that may have been accrued from the original trades.
Hedge Failure: It is very possible for a hedge to fail, especially if it is not applied correctly or if it does not respond as expected. Also, if the wrong hedge is used, it will not deliver to expectations.
Correlation Breakdown: It is possible for assets that are usually correlated to see a divergence in performance. In this scenario, the use of a correlated asset to hedge will fail. We have seen this in the current oil shock risk premium, where gold is no longer acting like a safe-haven asset but is displaying a two-way choppy consolidation in response to rising oil prices.
Costs: If hedges are used in the long term, the costs may eat up the long-term returns on trades.
Complexity: Some particularly bad trades may require the use of complex hedging strategies for recovery. These advanced hedge strategies may be beyond the scope of the retail trader’s understanding.
