Best Instruments for Hedging During Market Volatility

The year 2023 began with the Fed planning to wind down its monetary tightening, the Russia-Ukraine war intensifying, and covid-19 restrictions being eased in China. Such macro developments have a strong impact on the global financial markets and increases volatility across asset classes. As events and economic releases have the power to shake the markets, hedging becomes even more important to protect your portfolio while taking advantage of market volatility.

1. Benefits of Hedging

You may have been thorough with technical analysis and aligned your trading strategy with your risk appetite. You may have also been very disciplined about placing stop loss orders with every position you open. However, high market volatility tends to trigger false signals. Hedging is the next step in your risk management strategy as it involves taking a carefully thought-out position after observing market behaviour. It helps mitigate the possible loss of another existing position and gives traders peace of mind. Rationality is a valuable asset during difficult market conditions. Traders also use hedging to diversify an overly concentrated or high-risk portfolio and to avoid tax implications that may arise on closing a position.

2. Hedging Strategies

The first step in choosing an instrument is to understand the needs of your portfolio and creating a hedging strategy accordingly. Here are some popular hedging strategies.

A. Using Derivatives

These instruments derive their value from an underlying asset. Most often, they are traded using leverage to amplify potential gains, although this also increases potential losses in case the market moves against you.

CFDs: Contracts for difference are one of the most popular hedging instruments. They do not have a pre-decided closing date unless they are CFDs on futures. Traders can speculate in either direction, rising or falling markets. Also, the exposure is limited to the extent of the price movement, or the difference between the settlement price at the time of opening and closing the position, and not the actual price of the underlying asset.

A popular strategy is to open a larger position in the direction you expect the market to move and another smaller position in the opposite direction. This ensures that your losses are controlled in case the market moves against your prediction. You can also open CFD positions to hedge your investment portfolio, by shorting assets that you hold. Of course, if you are planning to trade CFDs, it’s vital to remember that if you were to trade company shares, for example, you would not have the same rights as a shareholder since you do not physically own the underlying asset. Trading with leverage also comes with potential risks as well as potential rewards – margin trading can potentially magnify profits, but also losses. Risk management tools are crucial for all traders.

Futures: These are standardised agreements for selling and buying an asset at a predefined date for an agreed upon price. The underlying asset may be a currency, commodity, or stock.

Options: They are similar to futures but allow you to decide whether to go ahead with the trade. With options, you have the choice to simply let the contract expire in case the market moves against you. Although losses can be minimised with options, the gains are also typically lower, since they allow traders to observe markets before making the final call.

B. Trading in Pairs

In this strategy, you take positions in two different trading instruments that have low correlation or are not corelated. For example, commodities have exhibited a low correlation with the US dollar.

Another popular strategy is to identify an asset that is overvalued and another that is undervalued. You can take a long position in the undervalued asset and go short on the overvalued one. The belief is that markets tend to correct over time.

C. Using Safe Havens

Certain instruments perform well when investor risk appetite is low. These are:

Gold: The yellow metal is considered a hedge against currency devaluations, bear markets, and accelerating downside volatility. Gold has historically maintained an upward trend, which is why many investors shift their funds to this metal during periods of economic and political uncertainty. This increases the demand for gold and boosts its price, while other asset classes may be declining.

Stable Currencies: The US dollar, euro, and Swiss franc are considered strong currencies that will not suddenly lose their value. During periods of uncertainty, investors may liquidate a part of their portfolio and convert this to cash. Investors tend to choose the US dollar and euro, as minor and exotic currencies do not perform well during challenging times. You may consider using the US dollar and euro to hedge against overall market volatility.

D. Average Down

This strategy is most commonly used by stock investors. Let’s say you’re long on an asset and its price is declining. You continue to open small positions in that asset as its price declines. This way, you’ve gone long on the asset at better and better prices. When the price corrects, you keep closing the winning trades.

E. Diversification

You may diversify your portfolio further by adding more assets to reduce the risk. Instruments like indices and ETFs allow you to achieve greater diversification with less funds. These instruments contain a set of assets that smooth out market volatility risks.

F. Using Cryptos for Hedging

Cryptocurrencies have gained popularity for hedging against economic and political risks associated with traditional asset classes. This is because cryptos are not dependent on any one economy and are not related to any one country. Trading cryptos can add another dimension to your traditional portfolio.

3. Things to Consider Before Choosing a Hedging Instrument

Your hedging strategy needs to focus on reducing risk of losses and should not end up being a profit-centred plan. Consider the following when hedging:

• The instrument you choose should help you achieve the objective of hedging against volatility and must align with your trading goals.
• Consider the buying, selling, and holding costs as well as tax implications to evaluate the efficacy of your hedging strategy. Use rationale and numbers to justify your hedging decisions, rather than relying on intuition.
• Ensure that your portfolio is not over- or under-hedged. Too little risk often adversely affects returns, defying the purpose of trading.

Key Takeaways

• The financial markets can become highly volatile due to changing economic conditions across the globe, fiscal debt levels, supply chain disruptions, and geopolitical tensions.
• Experts advise to balance your portfolio with a combination of high-, medium-, and low-risk instruments.
• You can hedge risks associated with your preferred assets by using derivatives like CFDs, futures, and options.
• Safe havens like gold and the US dollar are part of a well-balanced portfolio.
• Averaging down is a popular hedging strategy for risks associated with a single asset.
• Diversifying with indices and ETFs is a cost-effective strategy.
• Learn more about cryptos, as these have gained popularity for hedging traditional assets.

Open a live account with ADSS and explore a diverse set of instruments to hedge your investment or trading portfolio.