The Academy of Financial Trading

Hedging Explained

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Hedging explained

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Risk Warning

Hedging explained – the basics

Hedging is often considered an advanced investing/trading strategy but the principles of hedging are fairly simple

Most of us, whether we know it or not, actually engage in hedging in our everyday lives!

When you take out say insurance to minimise the risk that a possible injury will erase your income this is a hedge!

Okay, Okay – so what’s the fuss and why should we bother? And how do we apply the same?

Hedging explained

Hedging

A modest example….

Suppose we want to invest in the budding industry of Muffin manufacturing, but this industry is often susceptible to sudden changes, hence volatile

We might believe, despite this, that company A, who is the leader in its sector, will perform exceptionally well and its share price will rise

We might also know that its competitor, company B, will underperform in the best instance for both

Let us now imagine a sudden death occurs from Muffin consumption so the shares of Company A fall. In this event we might have hedged our positions by going short on Company B – that way we essentially reduce risk and hope to make an overall modest profit

Hedging explained

Hedging

Hedging applied to trading

In trading we are using a multiple range of asset classes, so we are not limited to the Muffin manufacturing sector!

Hedging would occur if we were to take both long & short positions on two asset classes both within the same sector

That way we know that should an outside event occur that affects all asset classes in this sector we will be hedged

Hedging

Another way to engineer this is to actually trade asset classes that are unaffected by global macroeconomic events

In effect this means the markets in our overall portfolio are not affected by the same underlying inputs

Hedging explained

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