What is Hedging? – Definition, Examples & Techniques


Hedging, employed by investors and businesses, is a risk management strategy aimed at mitigating potential losses or adverse price movements in financial markets by taking offsetting positions in correlated assets to protect against fluctuations in the value of an underlying asset. Hedging strategies can include various financial instruments such as options, futures contracts, and derivatives.

Financial hedging techniques operate according to the same enterprise risk management framework as insurance. The hedged holdings can cover any loss in the event of an unforeseen down market.

Hedging in a nutshell

  • Hedging is a risk management strategy to counter potential losses in financial markets.
  • It involves using correlated assets like options and futures to protect against price fluctuations.
  • Popular hedging techniques include direct hedging, pairs trading, and haven trading.
  • Binary options can also be used for hedging, allowing investors to limit potential losses.

Examples: How does hedging in financial markets work?

Hedging in financial markets works by applying various strategies to manage risks associated with different assets. It spans across commodities such as gas, oil, meat products, dairy, and sugar, securities like stocks and bonds, currencies, interest rates, and even weather conditions.

1. Example: Steel price

Consider a manufacturing company that heavily relies on steel for production. Concerned about potential price increases in steel due to market volatility, the company decides to hedge against this risk. They enter into a futures contract to purchase steel at a specified price in the future. This action allows them to lock in the current price of steel, protecting the company from any future price hikes. Even if the market price of steel rises, the company can still purchase it at the agreed-upon lower price, effectively mitigating their risk exposure.

2. Example: Currency trading

The high risk associated with currency trading stems from the erratic nature of the market and the rapid evolution of circumstances. Forex traders employ various hedging techniques to try and reduce this risk, such as taking opposing bets on two currency pairs with a positive correlation. The second choice is to have long and short positions on the same country’s currency.

What are typical hedging techniques?

Several hedging tactics have been discussed utilizing the instances above. This technique can hedge against borrowing costs, currencies, commodities, stocks, and other market variables using various stock futures and options transactions.

Here are three such tactics:

  • Taking two opposite positions on the same asset at once is direct hedging. For instance, you might open both a short and a long position on the same asset. It is a simple hedging method that is simple to implement.
  • Another popular method that likewise calls for having two positions is known as pairs trading; however, it does so with two different types of assets. It is best to hold one stake in an asset whose price is increasing and the other on an investment whose price is declining. The risk of the declining price can balance with the rising price. Finding two virtually equal assets makes pairs trading more difficult than a direct hedge. The result is to discover two companies with comparable fair values, but one that has overvalued and the other that has less value.
  • Another hedging method to consider is haven trading. For instance, you may have heard of investors buying gold when they fear that the value of their currencies may decline. Gold is considered a “haven” asset with long-term price stability.

How to do hedging with Binary Options?

Hedging a binary option involves purchasing both a put and a call option on the same financial instrument. The key aspect of this strategy is selecting strike prices that enable both options to be profitable simultaneously. Specifically, the strike price of the binary call option should be lower than the strike price of the binary put option.

Example of hedging with binary options on gold

Suppose we anticipate volatility in the price of gold, which has been fluctuating between $1800 and $1850. To mitigate potential losses, we can employ binary options for hedging:

  • Purchasing 50 binary call options for gold with a strike price of $1850, each priced at $40 with a payout of $70.
  • Simultaneously, buying 50 binary put options for gold with a strike price of $1800, each priced at $40 with a payout of $70.

Here’s a breakdown of potential outcomes:

Underlying AssetFalls to $1800Price moves between $1800 and $1850Rises to $1850
Investment in call options (50 contracts at $40 each)-$2,000-$2,000-$2,000
Investment in put options (50 contracts at $40 each)-$2,000-$2,000-$2,000
Binary call options payout (50 contracts at $70)$0$3,500$3,500
Binary put options payout (50 contracts at $70)$3,500$3,500$0
Net profit/loss-$500$2,000$500
  • Falls to $1800: In this scenario, the price of gold drops to $1800. Consequently, the binary call options expire worthless, resulting in no payout. However, the binary put options yield a payout of $3,500, offsetting part of the initial investment loss, resulting in a net loss of -$500.
  • Price moves between $1800 and $1850: Here, the price of gold fluctuates within the anticipated range. Both the binary call and put options expire in the money, resulting in payouts of $3,500 each. As a result, we secure a net profit of $2,000.
  • Rises to $1850: In this case, the price of gold rises to $1850. While the binary put options expire worthless, the binary call options yield a payout of $3,500 each. Thus, we end up with a net profit of $500.

This strategy allows us to limit potential losses if the price of gold falls significantly, while still benefiting from price movements within the anticipated range.

How tu use put options as hedging strategy?

You can purchase a put option and the opportunity to sell the shares at the same cost you purchased them when investing in derivatives for a modest cost. Most investors utilize diversity as a hedging strategy or own many investment types, so they don’t all decrease in value at once.

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About the author

Marc Van Sittert
Marc Van Sittert is an experienced Binary Options Trader and coach who is originally from South Africa. He started his career in 2014 by trading old-school Binary Options online. His main focus is on short-term contracts with 60-second trades.

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