Investment in share or stock market can’t be free from risk. Investors safeguard theirs funds from untimely stock market crash or sudden decline in prices by employing hedging in stock market trading.
Also, hedging is used by multinational companies to protect theirs contracts from the sudden fall in the foreign exchange rates.
Purpose of hedging in stock market trading
If one corporation of US has signed a contract with another that is in Australia in Australian dollar, the firm in US tries to sell the future contract of Australian dollar fearing that it may go down given the nature of currency market. This is termed as hedging trading strategy, usually, used to offset the one asset by investing in others.
Offsetting one asset mean if the first asset class is facing unexpected volatility or sudden decline in the currency value, it plays vital role.
What does hedging trading strategy mean?
It is an effective means to minimize the potential loss by buying or selling other alternative assets like stocks, or derivatives. Simply put, it is safeguarding mechanism in probability of potential loss.
Actually, the purpose of hedging trading strategy isn’t to make profit out of investment but to reduce the risk and safeguard capital that is already invested. Tactically, derivatives like options, futures, swaps are the best bets to hedge assets in danger.
What are derivatives?
Obviously, derivatives are the most popular means to hedge the risk of ongoing position. It is a right of the and derives its value from underlying financial assets like stock, bonds, etc.
In other words, derivatives are the financial contracts in the varying sizes and units. Suppose, if you buy Tata consultancy (TCS) future or option contract, you buy underlying value of TCS stock that usually displays in number of units. It is 150 units in a single lot.
Purpose of derivatives in stock market
In derivative market, speculators used to buy or sell derivative contracts hoping the value of underlying assets rise or fall in a certain period of time. Because, when the period of the contract ends, the whole investment has no value. Hence, within period of contract, one has to make money.
Importance of hedging strategy
But, by the means of investing in such derivatives, without investing whole money, by just buying future or option contract, banks, traders, or speculators could protect theirs investment in potential threat.
Logically, it is like insurance against loss. Stocks, bonds, debentures, commodities like gold, currencies like assets are best examples of hedging instruments one can use to hedge investment in position.
Unexpected volatility and fluctuation in market
Certainly, unexpected volatility and fluctuation are bound to occur in the stock market, currency exchange market, and in the commodity market too. So, it becomes indispensable to have a protective strategy in case of such fluctuations.
Naturally speaking, it is like paying premium to safeguard our life from unexpected events like insurance. A potential technique to minimize loss, Loss, protect profit from being eroded, or to safeguard invested position.
Last words on hedging in stock market trading,
Finally, apart from the above mentioned importance of hedging trading strategy, its role in day-to-day activities is no less as we frequently follow this to avoid unexpected or uncontrollable losses.
Surely, it is the last resort action to protect the interest of investors or corporates.
Solved questions on hedging in stock market trading
Let’s take a look at the following solved questions on hedging in stock market trading.
Q.1.What is the role of hedging in stock market trading?
Ans: Stock market traders, corporates, and other financial institutions apply this means to offset the one asset by investing in others.
Certainly, unexpected volatility and fluctuation are bound to occur in the stock market, currency exchange market, and in the commodity market too.
Stocks, bonds, debentures, commodities like gold, currencies like assets are best examples of hedging instruments one can use to hedge investment in position.
Primary and secondary securities