Hedging by Balancing Positions
One of the most popular risk management strategies is hedging by balancing positions. This strategy involves taking positions in both an asset and its corresponding futures or options contract. For example, an investor or trader may purchase an equity and concurrently buy an associated put option as a protective hedge. By doing so, the investor/trader is seeking to protect himself/herself from a decline in the price of the equity by selling it for a pre-determined price via the option.
This method of hedging is generally employed to limit the risk of the asset. It protects the investor/trader from the downside of the asset, while retaining the potential of the upside. By using this method, you are able to balance your positions in both the equity and the corresponding futures or options, thereby mitigating the risk of your exposure to the underlying asset.
This strategy is often used by portfolio managers in order to protect their portfolios from potential losses. The manager may purchase an equity and simultaneously buy a put option to limit the downside of the position. In some cases, the manager may even buy call options as well to increase their upside exposure from the position. By balancing out their positions in both the asset and the derivative, the manager can limit their risk exposure to the underlying asset.
This technique can also be used by individuals to limit the risk of their positions. For instance, an investor may be holding a long position in an equity, but is worried about its potential for a decline. In such a case, the investor may purchase a put option to protect their long position from falling too much. This can both protect the investor from losses and also potentially increase their returns if the equity rises substantially in value.
However, it is important to note that there are potential risks associated with hedging by balancing positions. For example, hedging using derivatives can be an expensive endeavor and carries with it the risk of devaluing the underlying asset. Additionally, these strategies involve a degree of complexity, and there is a chance the investor/trader may not be able to adequately understand the strategy and/or properly execute it.
Overall, hedging by balancing positions is a popular and effective risk management strategy. By taking positions in both an asset and its related futures or options contract, investors and traders can protect themselves from potential losses and increase their returns if the underlying asset increases in value. This strategy requires a degree of sophistication and understanding, and comes with associated costs and risks. Therefore, it is important for investors and traders to take the time to understand the strategy, its associated costs and risks, and how it fits their individual portfolios.
