How Can I Hedge My Investments?
Hedging strategies usually consist of the utilization of complex financial instruments, which are known as derivatives.
And two of the most common derivatives in the investment world are known as options and futures.
Although we won’t be going into the details of these derivatives, it is important that for now, just remember that with the help of these two derivatives you can form a trading strategy and tactics where a potential loss resulting in one investment is offset by a profit in a derivative.
Let’s just at a few examples of how derivatives work. Let’s assume that you own shares of Jackson’s Tequila Company (ticker: JTC). Although there is no doubt you have strong expectations of this company in the long run, you are still a bit uneasy about the short-term losses prevailing in the tequila industry.
So, to hedge yourself from these losses in JTC, you can purchase a put option, which is a derivative of JTC. This option enables you to exclusively exercise your rights to sell JTC shares at a particular price, which is known as (strike price).
This tactic is popularly known as a ‘married-put’. So, what happens is, when you begin to experience a drop in JTC share price, below the strike price, these losses incurred will be countered by gains in your put-option.
Another classic example to explain hedging consists of a business organization that depends on a specific commodity.
For example, let’s assume that Jackson’s Tequila Company is a bit on edge about the volatility in the price of a crucial element that helps make quality tequila, known as agave.
The business could take a damaging blow should the price of the plant agave increases exponentially – which would no doubt result in reduced profits.
So, in order to protect or hedge against the volatility in agave prices, JTC can effectively form a futures contract (or sometimes known as forward contract, which is less regulated), enabling the business to purchase agave at a specific price set sometime ahead in the future.
This enables JTC to form its budget effectively without having to worry about the price fluctuations of agave.