Hedging Made Simple: How Smart Investors Stay Safe

Risk is often viewed as a simple dilemma – win or lose. However, professional managers know risk as a complex structure. Suppose you buy car insurance. You don’t want your car to crash, and if it crashes, the insurance will save you from financial ruin. Similarly, when you invest, there is a risk that the investment may result in a loss. It may be due to price uncertainties, global tariffs, economic policies, and other factors.  That’s where hedging comes in. Hedging is not about preventing losses or making money; it is about avoiding losses and preserving cash flows. When you hedge, you are essentially playing with the possibility of maintaining your gains.  

Many traders today seek opportunities to generate profits by hedging on short-term trades, whereas hedge fund managers utilise hedging to preserve capital. Hedging is typically a defensive manoeuvre rather than an aggressive trading strategy. The core purpose of hedging is to maintain stability and ensure protection from surprise price fluctuations.  

Example: 

Consider a farmer who wants to sell 100 kgs of wheat during the harvest season. If the price of wheat collapses before harvest, the farmer’s income disappears. To avoid this, the farmer would sell wheat futures to lock in a price before harvest. If the price falls, the profit on futures reduces the loss incurred. Similarly, the same approach can be applied to crude oil prices, gold price volatility, currency fluctuations, and commodity price fluctuations.  

Hedging Instruments: 

1.   Futures:

A future contract is an instrument that allows the investor to buy or sell an asset at a predetermined/fixed price on a future date. This ensures higher liquidity, allowing investors to enter and exit positions easily. Prices are determined by buying and selling on regulated exchanges, so that everything is transparent. These are standardised contracts, and all parties to this contract should honour the agreement.

A fixed premium is required to enter into the contract, which could burden the investor's cash flow while exposing them to a higher-risk environment.

Example: 

Suppose you are an oil company and you want to import crude oil 3 months from now for refining. But the prices in the market are very volatile, and you don’t like the prices to rise by the time you have to make the purchase. By entering into a crude oil futures contract, you can lock the price now and make the purchase later at the locked price. If the price of crude oil rises in the next 3 months, you will buy it at a discount. But if the price falls, you buy the crude oil at a premium. 

2.   Options: 

Options are similar to futures, but they give you the right (not the obligation) to buy or sell the asset. This provides the investor with flexibility and can help them exit unprofitable situations. This contract also allows you to set custom lot sizes, strike prices, and expiry dates. However, this does not mean completely risk-free. Entering into an options contract requires an upfront payment, known as the premium.

Example: 

Consider that you want to buy gold but are worried about the price rising. So, you enter into a gold options contract to reduce the risk of the price going up. If the price goes up, you exercise the contract and buy gold at the agreed price. But if the price goes down, you don’t exercise the contract and buy the gold at the market rate. The only loss in this situation would be the premium paid. 

3.   Forwards: 

A forward contract is the same as a futures contract. Unlike futures contracts, forwards are traded on the OTC (Over-the-counter) market, which is not regulated by any statutory body. These contracts can be customised to meet the investor’s specific needs.  

These types of contracts carry counterparty risk (i.e., one of the parties can default). These contracts are also not regulated, so no protection is guaranteed against unfair practices. 

Example: 

Tata Consultancy Services earns most of its income from US companies. They enter into a forward contract to exchange dollars at a fixed rupee rate. This ensures that they are safe from currency appreciation/depreciation. 

4.   Swaps: 

Swaps are an exchange of cash flows between two parties. These are primarily used for interest rates and currency swaps.  

Example: 

Suppose A has a floating-rate loan but wants guaranteed fixed payments. B, on the other hand, has a fixed-interest-rate loan but wants floating payments for a chance at earning some profit. Both parties enter into a swap contract. A gets fixed rates from B; B gets floating from A. Both parties get what they wanted without changing their loans. 

Conclusion: 

These types of instruments are just some of the ways that an investor can practise hedging. Hedging serves as a disciplined approach to mitigate the risk and uncertainty associated with a specific investment. It can be viewed as an ongoing process for monitoring a person’s portfolio. Investors can use hedging to stabilise their cash flows, protect capital and ensure that their returns are protected. 

Authored by: Aryaveer Batra