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Hedging is sort of Insurance. Like when we buy a car we also buy an insurance. Similarly other insurance products like life insurance, loan insurance etc. These are basically hedge against certain problems in our lives.
Hedging is the same. If take a trade and hedge it properly rest assured that the loss will be limited because hedge will make sure the losses are limited.
Hedge reduces or eliminates fear, one of the worst enemies of trading. It reduces fear because the trader knows that his loss is going to be limited. In that case hedging allows him to take a bigger trade.
Imagine a trader trading 10 future lots without hedging vs a trader trading 10 futures lots with hedge – both taking a long buy call. And if this is an overnight position the trader trading without hedge will not be able to sleep.
Hedging is not just an insurance as written everywhere, its most important feature is it reduces fear of trading.
What Exactly Is Hedging?
It is an investment or trade with negative correlations. It is like becoming a broker. Take money from one trade and give back money on another – the difference is the profit of the trader.
It is obvious that if the trader is reducing risk in the trade, then profits will also reduce. However, if the original trade makes a loss then the insurance pay off a lot which in turn reduces the losses.
Which type of traders are big hedgers?
Portfolio managers, high net worth individuals, conservative retail traders, and corporations trading in millions of dollars almost always hedge their positions.
Just like insurance hedging comes at a cost. But the benefit far surpasses the cost of hedging especially when the trade goes against their bet.
Instead of losing millions of dollars or rupees, they lose only a few lakhs. But when they make money, it’s only a small price they pay for hedge. All in all over a long period of time they make good money.
Even if it is 30 crores profit made on 100 crores of rupees this is a great return.
It is due to hedge that they are able to risk 100 crores, otherwise it is impossible to trade with 100 crores naked trading.
Do High Net worth Investors Hedge?
Yes they do. They trade with a lot at stake. Sometimes they also trade with borrowed money. When they are trading with millions of dollars they cannot even think of taking a big risk. Naked trading is winner takes all and loser loses all.
Winner takes all is fine, but when it comes to losers lose all, they have a problem.
HNIs mostly buy stocks worth crores and they hedge it with derivatives. When they feel stocks may fall they buy Put to protect the losses from the fall.
How many puts to buy and the strike price to buy puts depends on the pricing of the puts and the risk they feel on the stock’s fall.
If their data suggest there can be a huge fall they buy more puts and if they feel the stock may not fall too much they buy less insurance or hedge. This strategy is known as Married Put mostly done by high net worth individuals.
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