Hedging is a common strategy in trading and investing in financial assets. It’s a term that appears very often in financial discourses, and rightly so. Have you ever wondered what it is, how it works, what we use it for, and the pros and cons? If yes, then today is your lucky day!
Hedging simply is the trading of a financial asset to counteract the effect of another trade. It involves using other financial assets to offset unfavorable market movement in an earlier trade. It is especially useful when dealing with derivatives, be it in stocks or cryptocurrencies.
Hedging may involve several sub-strategies depending on the policy of the trading party. A practical example of how hedging works is opening a short position despite having a long position open simultaneously. That means the trader buys an asset but suspects it will drop in value, resulting in a loss. Thus, he opens a sell position simultaneously, recovering his losses in one trade from the other trade. This could also be deployed by buying inverse assets of an existing investment. An example is buying or longing a crypto futures contract, then also longing an inverse contract of that crypto (a contract that increases in price as the crypto asset decreases in real-time).
Hedging is a risk management tactic. Therefore, it’s especially important for newbies and experts alike. It is one of the most reliable risk management strategies in finance. That makes up its major pro. Your trades are safe when you’re hedging. However, the reduction in risk creates a corresponding reduction in reward. It sacrifices larger rewards for safety. Plus, the double trading costs, as well as the relatively unchanging outcome of the trade, give the brokers an edge over the traders in forex. This is the reason the CFTC has declared hedging in forex trading illegal in the United States.
