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A Dummy’s Guide to Hedging in the Stock Market

Hey fellas. Sorry for the delay. Was relaxing and enjoying my holidays. We take time, because we believe in providing quality. And quality is what keeps us ahead of the rat race. But now I am back and “back” with a new post.

Past couple of weeks have been very volatile. And all many of you have requested me to post something on hedging to reduce the risk in the volatile market. So today we will take up the basics of hedging for the beginners. Advanced lessons will follow suit.

So what is hedging? Well, all of you who requested that I take up this topic, have already answered the questions. The definition or the meaning of hedging is making an investment to reduce the risk of adverse price movements in a given asset.

In layman’s language, hedging is reducing or controlling the risk. We can hedge by creating a position in the futures market that is opposite to the one in the spot market with the aim of reducing the risks associated with price changes in the asset class.

Best example for hedging can be – An oil importing company can sell crude futures to protect its investment in oil till the time it has supplied the oil in India. If there is a fall in price of Crude, the loss in the cash market position will be countered by a gain in futures position.

So after understanding the meaning of Hedging, lets understand how it’s done

In Hedging, the hedger tries to fix the price at of a certain underlying at a pre-defined level with the objective of ensuring certainty in the cost of production or revenue of sale.

Let’s understand this deeply with the examples:

Example – Hedging in Steel

A car manufacturer like Maruti Suzuki purchases huge quantities of steel as raw material for automobile production. The company enters into a contractual agreement to deliver Swift cars to the dealers in Europe in three months.

Now the contractual obligation has been fixed for the company at the time of signing the contractual agreement for exports. The car manufacturer is now exposed to risk in the form of increase steel prices. In order to hedge against price risk, the company can buy steel futures, which would mature three months hence. In case of increasing or decreasing steel prices, the company is protected.

Let’s say if the prices of Steel decreases the losses in the steel futures bought by the company is offset by the spot prices. If the prices increase than the profits in the futures bought by the company also increase. This offsets any uncertainties in the price fluctuations in the prices of steel, thereby limiting the losses which may have arose due to the fluctuations in the spot prices in steel.

Let’s now understand different types of hedging:

Buying Hedge

A buying hedge is also called a long hedge. Buying hedge means buying a futures contract to hedge a position created in cash market.

Benefits of buying hedge strategy:

  • To replace inventory at a lower prevailing cost.
  • To protect uncovered forward sale of finished products.

The purpose of entering into a buying hedge is to protect the buyer against price increase of a commodity in the spot market that has already been sold at a specific price but not purchased as yet.

Long hedgers are people or companies who have made formal commitments to deliver a specified quantity of raw material or processed goods at a later date, at a price currently agreed upon and who do not have the stocks of the raw material necessary to fulfil their forward commitment.

Selling Hedge

A selling hedge is also called a short hedge. Selling hedge means selling a futures contract to hedge the prices in the spot market.

Uses of selling hedge strategy.

  • To cover the price of finished products.
  • To protect inventory not covered by forward sales.
  • To cover the prices of estimated production of finished products.

Short hedgers are people or companies who buy the commodity in the spot market and who simultaneously sell an equivalent amount or less in the futures market.

The hedgers in this case are long in their spot transactions and short in the futures transactions.

We hope you have now thoroughly understood the meaning and concept of Hedging.

We will also discuss the techniques of hedging in detail in our upcoming blogs. Also we will take up arbitrage basics as well as well as techniques in the upcoming blogs. So stay tuned and keeping visiting TradeTalk for more informative blogs.

Till than have a great time trading. We will see you all soon.

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Pratyush DixitConsultant - Digital Marketing and Content

Pratyush is a Post Graduate in Marketing Management and has a leadership experience of nearly a decade in diversified industry including Stock Broking. Having headed companies for over half a decade, Pratyush brings with him, rich Marketing and....

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