Trading in stock market is like a high school topic for all and so are the terms like currency, share market, stock trading, equity etc. There is one term that brings in a slight confusion and different angles of representing. That is hedging, a comparatively less touched upon the aspect of stock trading, primarily due to its first look at being a very advanced investment. However, in reality, the principles and strategies of hedging are quite simple and is different from hedge funds.
Hedging is acceptable and a part of your routine life
You may have abruptly cut calls from insurance companies or agents, but still know that in this world of uncertainties, having an insurance cover always adds to your security. Let it be your vehicle, your home, your job, health, your family’s future or your well-being; insurance now covers almost all aspects of human life. You transport your household furniture with the security of insurance, and you purchase a travel ticket having an option of getting insured. If so, why should you consider investing in hedging as an inappropriate concept? It is a kind of lifeline in the share market, which is a risky business in itself. Hedging is also a kind of insurance that gives protection against possible heavy losses in share market investments. That is, it reduces the risk factor associated with these kinds of investments and also helps in increasing the earnings.
Pairs trading is a type of hedging in which you can surpass industry risk by simultaneously investing in two industries of the same sector and exercise two different options. In this way, the loss you can incur due to volatility in the sector market can be compensated by the two ends of the investments.
Take the example of branded textile manufacturing industry. You invest in one company having an excellent history and present performance that makes cotton clothes. Here you go for a long option and invest in a company manufacturing synthetic clothes by going short. The demand for branded clothes depends on the higher income groups, seasons and taxation policies.
Both the companies might be making high profits giving you good leverages but a sudden inflation, economic slowdown or peace violation might result in the mass loss of high-end jobs. This result in reduced takers of branded clothes and the entire industry take a hit. The loss you make by going long in the cotton textile company may be compensated by the income you make by going short in the synthetic textile company. This is how hedging saves your day.