The financial risk management is a vast area to study and also understand how to manage risk. This gets more challenging as technology plays a vital role in the current industry. In this tricky scenario, we have the help from the hedging technique which is a life saver to reduce risk and make better profits.
Hedging is a method to reduce the risk it is not a long-term strategy though. But it can be catered according to the need of the hour. Hence there are different types of hedges that can be followed. Some of the prominent ones are:
1. Pairing: pairing is to find a similar security like the one which is in a risky state. The similarities could be in terms of characteristics of the industry or sector categorization, market capitalization, dividend yield, volatility, price to earnings ratio. Once we are able to find a pair of two securities with similar features it becomes easier to correlate them and hedge in order to reduce the risk of loss.
2. Shot against the box: this is a unique technique in which securities are sold using short selling the same stock. This was a common technique used by many high net worth companies and hedge funds to avoid the capital gains occurring from these.
3. Futures: this is a typical contract between two parties to buy or sell securities at a later date at a particular price in future. This will eliminate the risk during the remaining period as the security is not in the trade. Therefore this is one of the most common derivates used to hedge risk.
4. Exchange traded funds: these are the types of funds which have a wide hedging option. This is traded like a stock on day to day basis hence it would be an ideal option to reduce the risk associated with the price change. These stocks can be sold as and when required and don’t have any extra brokerage or commission, thus making the process easy.
5. Options: this is one of the most complex tools for the hedging function. This requires an in-depth knowledge so that it can be executed rightly for risk aversion. Some of the specific types are covered call option, buying a put option and collaring.
Therefore, it is important to understand which type of hedging will suit your type of security and also the market force which affects the price should be analyzed so that the perfect choice can be made for the best interest of the trader.