Hedging: Safeguarding Investments through Risk Management

One of the most common ways to hedge a stock portfolio is with options, which give you the right, but not the obligation, to buy or sell a security at a predetermined price before a certain date. Let's say you own a significant amount of stock in a company but are concerned about short-term volatility in the broader market. You could buy a put option on that stock, which gives you the right to sell the stock at a specific price. If the stock price drops significantly, your put option will increase in value, offsetting some or all of the loss from the stock.

Short selling is another technique used for hedging. If you believe a particular stock in your portfolio might decrease in value, you can short sell the stock, which involves borrowing shares and immediately selling them with the expectation that you will be able to buy them back later at a lower price. If your prediction is correct, the profit from the short sale will offset the loss in value of your owned shares.

Futures and forwards are contracts that obligate the buyer to purchase an asset, or the seller to sell an asset, at a predetermined future date and price. For example, if you hold a portfolio of stocks and fear the entire market might decline, you could take a short position in a futures contract on a stock market index. If the market does indeed fall, the gain on the futures contract can offset the losses in the stock portfolio.

 Inverse ETFs are designed to increase in value when a particular index or sector decreases in value. If you own a portfolio of tech stocks and believe the tech sector might face a downturn, you could hedge by buying an inverse tech ETF. If the tech sector does fall, the inverse ETF should rise in value, helping to offset your losses.

You can also hedge by diversifying your portfolio among different asset classes, such as bonds or commodities, that may not be correlated or might be inversely correlated with stocks. This way, if your stocks fall in value, your other investments may hold steady or even increase, helping to balance out your losses.