Financial hedging is a poorly understood side of the financial market. There are many different types of hedging used with different purposes in mind. One purpose is to bet for or against the market that it will move one way or another. Another purpose is to provide increased financial security in various forms to investors which is what we will be discussing in this article.
Here are a few ways that financial hedging is helpful in providing greater levels of financial security.
Reducing risk without needing to sell
When looking for financial hedging solutions, what you want is more options than you began with. For instance, let’s say that you owned some gold which had appreciated in value over time. You wanted to protect against a substantial reduction in the value of your holdings, but you don’t want to be forced to sell to remove the market risk of owning gold. One way to handle this would be to financially hedge against a decline in the price of gold where you pay a premium to protect against a substantial loss, while possibly giving up some of the upside in the process.
Every deal is different. In the above example, protecting against a substantial loss in value during a turbulent time, without creating a taxable event by selling the gold position, provides insurance against a steep downward price move. Protecting against a steep decline in the value of the gold holdings is akin to acquiring an insurance policy. When having a substantial percentage of your net worth in a single asset, that kind of insurance allows you to sleep well at night.
Buying in the future, but at an affordable price
Some people or businesses may know that they will need to buy a commodity at some time in the future, perhaps 1-2 years from now. Their concern is that whilst they may have the money set aside now for the future purchase, the cost could rise substantially because the price of commodities is highly variable.
To protect from a large increase in the purchase price, they could buy a commodity call option based on the future purchase price where the option strike rate is set. In other words, an option strike price of $100 per barrel could be set where if the price becomes $150 for a barrel of crude oil, exercising the option would permit the buyer to still only pay $100. If the price of oil falls below $100, the option can expire, and oil is bought at the discounted live price. The buyer of the option pays a premium of several percentage points on the value of the deal which protects them from more substantial price movements that would be far costlier.
Protecting from a worst-case scenario
When a business must buy something at a future date and can only afford to pay so much, using financial hedging is a way to make this happen. It is a form of business insurance and can be thought of along these lines. Investors with a substantial portfolio can continue to own their investments but hedge against certain risks at the same time, like an interest rate hike or a market crash. This can either be to completely limit the downside, or to subdue it and accept some of the potential loss in exchange for an affordable premium paid when taking out the option.
There’s usually an option that can be purchased which will provide protection if the buyer is willing to accept the cost of doing so. Just like with insurance policies, they cost money whether you claim on them or not, but when risk mitigation is what’s needed, they can be extremely useful for financially sophisticated people to use at the right time.