Hedging as a risk management strategy

At their core, hedges are designed to reduce exposure to risk, making them a useful tool for individuals and businesses alike who can benefit from reduced risk and volatility or protection against price declines. Hedges have a lot in common with insurance policies. Insurance policies, including homeowners, medical and car insurance, can help you avoid unexpected costs and reduce potential out-of-pocket expenses. For traders and investors, hedges are a great way to protect your portfolio from price declines. Hedges let traders offset potential losses on certain assets in their portfolio, with the aim of improving their overall returns. Derivatives give traders the chance to create a hedge against spot holdings in their portfolio. The simplest example is a short position. The basic idea behind a short position is that you think the price of an asset is going to go down (if the price goes up, you could lose money). When you open a short position, you’re basically selling an asset with the plan of repurchasing it later at a lower price.

Things to look out for with hedging

Hedging isn't without its drawbacks. Hedging can also mean you miss out on some potential gains. If the market moves in your favour, you won't be able to enjoy the full gains because your hedge position will decrease in value, offsetting some of the gains from the corresponding asset. For instance, let’s say you’ve hedged your spot bitcoin holdings with a short futures contract on the price of bitcoin. If the price of bitcoin goes up, your unrealised gains will be lower than if you hadn't opened the short futures contract, as your gains from the spot holdings are at least partially offset by the losses in your futures position. The type of hedge you use can also make it expensive. You might have to pay a premium to enter into a derivative, such as a futures contract or option, that can act as a hedge against other assets in your portfolio. As a general rule, assets with greater volatility or downside risk will have higher costs associated with hedge positions. Hedging can also bring new risks depending on the type of investment you use for the hedge. For instance, if you set up a hedge for your spot holdings of bitcoin by opening a short position with a futures contract, you'll have to watch out for the risks associated with leverage.

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