What is Hedging and Why You Should Do It?

May 31, 2021

Тrading of any type of financial instrument is not easy and should not be approached in the same way as one would gambling. When trading, you should not only aim to appreciate your initial portfolio but also protect it against losses. Unfortunately, no tool can guarantee you would not suffer any losses, but you should at least try to reduce your risk exposure.

In fact, “hedging” is the term describing the useful practice of investing in financial instruments with the purpose of cutting losses that may or may not occur in the future. Think of it as insurance — your car may or may not break down down the road but it’s nice and potentially much less expensive to be prepared for whatever happens.

What is Hedging?

At its core, hedging is a risk management strategy used to ensure your portfolio against various risks such as increased volatility, market corrections, black swan events, or other adverse price movements that diminish its value. You hedge against the potential price volatility of one asset by taking an opposite position using a financial instrument based on that same underlying asset or on a correlated one. More on that later.

Hedging requires an additional investment in order to cut potential losses, the same way insurance does, but in the case of financial markets, traders hedge one investment by making another. Thus, using hedging strategies usually results in reduced profits and does not maximize potential gains. However, it brings balance and predictability to your portfolio.

Hedging Instruments

Hedging can be performed by using different derivative products.

Derivatives are financial instruments whose value, risk, and basic term structure all derive from an underlying asset or set of assets. The underlying asset may be equity, security, interest rates, currency, commodity, market indexes, etc. Derivative contracts have a price and an expiration or settlement date usually set in the future.

The main types of derivatives used in hedging are options and futures contracts.

Options are a category of financial derivative instruments. When buying an option, the buyer gets the right, but not the obligation to acquire or sell the underlying asset at or before the expiration date. The buying price of the option is called the “premium”, whereas the predetermined price of the underlying asset is called a “strike price”. There are two types of option contracts: call option gives the holder the right to buy the underlying asset, while put option — the right to sell it.

Futures, on the other hand, bring an obligation for the holders to buy or sell the underlying asset at the predetermined price and date. The pre-set price may strongly defer from the current market price which is why futures are mainly used to prevent losses from sharp and unfavorable price changes in asset value.

How Does Hedging Work?

Hedging is an investment practice used to manage risk by taking an opposite position in a related asset.

In practice, if one asset’s price increase is set to hurt your portfolio, you may consider buying a correlated derivative that moves in the opposite direction..

It would be best to break this down with an example:

Let’s consider a steel rebar production company. The main raw material it uses is steel scrap and, in order to not slow down production and ensure order fulfillment, the company will be buying steel scrap regularly over the coming months. Currently, the steel scrap’s price is $430 per tonne, but it is expected to increase. To remain competitive and profitable the company would need for the steel scrap price to remain as low as possible.

The company may buy a call option that in six months will provide the right to buy steel scrap for the same price of $430 per tonne. Depending on the current market price, the company may decide whether or not to exercise that right.

Meanwhile, there is a six months futures contract available that offers a tonne of steel scrap for $420. If the company opts to purchase it i.e. to take a long position, it will guarantee a price of $420 per tonne when the delivery date arrives.

Six months later, the market price for steel scrap has jumped to $460 per tonne. Either of the two hedging instruments has proven to be useful. If the company had chosen the call option, it had saved $30 per tonne, whereas the futures contract would have saved it $40 per tonne. However, if no hedging strategy was undertaken, the company would have lost $30 per tonne.

Furthermore, these fluctuations in raw material prices would most likely affect the prices of the final product — steel rebar. Thus, our company may employ another hedging strategy to insure against those volatility risks. Let’s say the steel rebar price is currently $500 but the market sentiment suggests it is about to fall.

The company may buy a put option (a right to sell) and guarantee that in six months it can sell its steel rebar for $490 per tonne. If the prices remain at the current levels, the company will not exercise its put option and the only loss it would have endured is the price of the option itself (known as the premium).

The company may also decide to take a short position and issue a six months futures contract for $480.

After six months, the market price for steel rebar has dropped to $450. Using the put option the company has effectively arranged a buyer for its product at a price higher than the market one. Thanks to hedging, the company has managed to avoid major financial losses.

Hedging for Speculators

However, manufacturers and companies whose business activity depends on the traded asset are not the only ones who invest in commodity derivatives. Investors and speculators also participate in the commodity derivatives market to earn profits or diversify their portfolios.

Commodities markets are relatively stable and are often used as a hedge in times of high stock volatility and inflation. Speculators invest in commodity derivatives to profit from price fluctuations and since they don’t actually hold or need the underlying asset, they can close their positions long before the contracts’ maturity date.

Here’s an example:

A trader who usually invests in the stock market is worried about the rising volatility and decides to hedge against it using metal derivatives. They have heard on the news that China announced a huge infrastructure project that would probably increase the demand for steel. The trader has previously observed that such events lead to price increases and decides to take a long position with a steel futures contract. They enter a six months futures contract for $1,300. Three months later the price of steel rises to $1,560. The trader sells their futures contract and earns a 30% profit. Effectively, they have successfully hedged against price fluctuations by offsetting some or all of the losses generated on the stock market.

It should be obvious though that commodity derivatives trading is still risky and requires experience, research, and knowledge of the fundamentals of supply and demand. Traditional leveraged instruments are usually high risk and may lead to losing more than one has invested. For these reasons, novice and inexperienced traders may be unable to open accounts with brokerage firms or trading applications or may be able to do so only if the trading volume they generate is kept within a certain limit. Furthermore, most traders may find that access to derivative products is too expensive due to high brokerage fees, net worth requirements, and margin requirements.

The Cost of Hedging

Trading derivatives and commodities, in particular, is usually linked to high expenses and is traditionally not accessible to everyone. To be able to invest in options and futures in the commodity space you need to have an approved margin account with a brokerage firm, top it up with your own cash, and comply with multiple requirements. Trading futures for instance is subject to various margin requirements:

A Margin is what you have to pay the broker to trade futures. It is a percentage of the transactions you can make and is fixed at the maximum possible loss that you could incur. Margins will be higher in volatile markets. Margins can be broken down into Initial Margin Requirements and Maintenance Margin Requirements.

On top of these margins, we need to consider that futures markets typically use high leverage.

Leverage means that the trader does not need to put up 100% of the contract’s value amount when entering into a trade. Instead, the trader is required to deposit the initial margin amount, and a maintenance margin is a minimum equity an investor must hold in the margin account after the purchase has been made.

When using a margin i.e. trading with a borrowed capital, a trader must ensure that the total value of their margin account does not drop below the broker’s required amount. If that happens — a margin call occurs. The value of the account, which is based on market prices, is known as the liquidation margin. If the liquidation margin becomes insufficient to support the trader’s positions, the broker may liquidate those positions to reduce their risk. (Investopedia)

In the case of option contracts, the trader will have to pay a premium to the seller of the option. The cost of the option will depend on volatility and expiration time. The premium is not refunded to the trader irrespective of whether they use the option or not.

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Now that we have introduced hedging and considered the costs of implementing it, we will focus on the crypto space and where the Mettalex DEX fits in.