In one of my previous posts, we have understood the assessment of our portfolio risk by computing the portfolio beta value. Knowledge of our portfolio’s volatility can provide useful information in order to make decisions to manage the risk associated with the uncertainty of the market . You have put in substantial amount of time and resources in order to build your investment portfolio, but it is equally important to manage the risk associated with it. As we already know, timing the stock market or any global affairs that have direct impact on the market is nearly an impossible task. For this reason, we must ensure that we build a safety net to manage our risk with hedging.
What is hedging?
In its simplest forms, hedging is an insurance policy for your investments. It involves making an investment in order to offset the positions we currently hold in the market.
Let’s understand this with a very simple example of Max who is an exporter of aluminium scrap. Current times have shown great volatility in aluminium prices with a looming trade war. How can Max secure himself from losing money before even selling his inventory by hedging his trade?
Consider that Max exports 100 tonnes of scrap aluminium each month and expects to do so at the beginning of next month. The current scrap aluminium price is $2,000/tonne. If he sold it today his total selling price would be:
Total = $2000 x 100 = $200,000
Max has agreed to sell this scrap aluminium to Germany after 30 days, but is uncertain about the price during this time period. He believes the price of aluminium can decrease during this time period, which will reduce his profits. Let us say that in 30 days the price is $1,900/tonne.
Under normal circumstances, Max will only get $190,000 to sell this scrap. Now instead of simply giving in to market fluctuations, Max decides to visit this blog post and make the sound decision of hedging his trade to reduce his risk 😉
He purchases a futures contract that allows him to offset this risk. A futures contract is simply an agreement to buy or sell assets or commodities at a fixed price to be purchased and delivered at a later date. Thus, if Max buys a 30 day futures contract for aluminium, it allows him to sell the scrap at a fixed price 30 days from now.
Let us say the futures contract allows Max to sell 100 tonnes of aluminium at $2,010/tonne. After 30 days Max receives $201,000 as opposed to $190,000 regardless of the price fluctuation. Max just saved himself from incurring a loss of over $10,000 by hedging his trade with the purchase of a futures contract that locked in his price of trade.
Such contracts are available for a wide variety of assets, mainly commodities. For international trades, traders often hedge their positions to prevent any losses due to fluctuations in currencies. Similarly, stock investments can also be hedged by purchasing futures contracts for individual stocks or the entire index.
CAUTION with FUTURES:
Hedging must be used in order to reduce or mitigate the risk. However, there are a large number of traders that claim to make quick money using this strategy. This is not a get rich scheme, and you must be cautious to prevent yourself from making any foolish decisions. Let me give you a simple example why this strategy can very quickly trick you into losing all your hard earned savings.
Max fully understands the idea of hedging, but starts becoming greedy looking at the upside potential of futures. Although he is an aluminium trader, he now starts focusing on another fluctuating commodity – oil. He decides to purchase a 30 day contract for 1000 barrels of oil at $70 per barrel. His total cost after 30 days would be $70,000, but Max has no use for this oil and can simply sell his futures contract during these 30 days. Max expects the price of oil to increase during this time, allowing him to make a quick profit.
The best case scenario is when the price of oil reaches $75 during these 30 days, and Max can quickly multiply his money with a $5 profit per barrel of oil, earning him $5,000 in total for his smart trade!
The downside is when the price of oil drops to $60, and now Max will be forced to sell his contract at this price losing $10 per barrel and a total of $10,000!
Futures contracts are not free and you must maintain a margin account and pay an upfront initial margin when acquiring the contract. It may seem like purchasing a large investment for a small sum of money, but the downside risk of such investments can incur heavy losses.
To be successful at investing, do NOT rely on short term trading strategies. Your goal is to ensure long term sustainable growth as a value investor and no matter how attractive trading may appear, stay away from it!
Be Frugal, Be Smart, Be Rich!