10 Advanced Hedging Strategies To Reduce Your Portfolio Risk

What is hedging?

Financial hedging involves using different financial instruments and strategies to offset the risk of any negative price trends on your assets. Usually, that’s done by investing in assets that have a negative correlation with each other. 

It helps you minimize risk and limit losses if your assets depreciate. But depending on your investment assets and goals, some hedging strategies might be more effective than others. 

Let’s discover the 10 best hedging strategies, including trading safe-haven assets like wine and how Vinovest can help you start your wine investment journey. We’ll also cover the advantages and disadvantages of hedging and the answers to any other questions you may have.

How Does Hedging Work?

As we saw above, hedging is about investing in assets that are negatively correlated to each other. 

If one asset depreciates, the other one appreciates, and the loss of the first asset is reduced with the profit from the second one. While hedging doesn’t protect you 100% from price risk and losses, it helps you reduce their negative impact.

Another popular way to offset financial losses is to buy put options. For example, let’s say you have bought shares of XYZ company, but now you believe they will soon start decreasing in value. To protect yourself from the loss, you can buy a put option that gives you the right to sell your shares at a specific price (also known as the strike price.) So, if the stock crashes, you can offset the losses by the profit you make on your put option.

Hedging is mostly used by short–term and medium-term investors since such market volatility periods are usually short-lived. 

Next, let’s see the main hedging strategies you can adopt to protect your portfolio. 

10 Types of Hedging Strategies

Here are 10 hedging strategies you can use to protect your portfolio:

1. Trading Safe Haven Assets
2. Asset Allocation
3. Derivatives
4. Pairs Trading
5. Arbitrage
6. Spread Hedging
7. Average Down
8. Delta Hedging
9. Hedge Funds
10. Staying in Cash

1. Trading Safe Haven Assets

One of the most conventional hedging strategies is to trade safe-haven assets like wine, gold, currency pairs, or Government bonds.

Let’s look at each of them:

Wine

Fine wine is an increasingly popular alternative investment, preferred in times of inflation and other economic instability periods. With the fine wine market expanding and prices appreciating steadily in the long term (since supply decreases but the demand for the finest vintages increases), wine is a great hedge investment.

And the best part is you don’t need to be a wine expert or an accredited investor to start investing. Anyone can tap into the lucrative wine investment market with the help of Vinovest. 

Vinovest is an advanced AI-based wine investing platform that allows you to buy, authenticate, store, and sell some of the most renowned wine labels in the world with just a few mouse clicks.

Gold

Gold is another stable asset investors try to hold onto in times of high market volatility and economic turmoils. The value of gold has appreciated by 300% since 2005, outperforming Dow Jones (153%), so acquiring this asset can offset any potential loss on the stock market.

Currency pairs

Strong currencies like the US dollar (USD) and foreign currency like the Swiss franc (CHF) are considered stable since they have consistent exchange rate and low currency risk. That’s because their economies are strong and are less affected by market volatility.

Government Bonds

Government bonds provide a fixed return rate even in market instability periods. These investments are generally preferred by less risky individual investors since they’re quite safe - they won’t increase your fixed income substantially, but they carry minimum financial risk.

2. Asset Allocation

Asset allocation is a way for investors to diversify their portfolios by investing in different asset classes. This simple but effective hedging strategy helps you spread risk across multiple assets. 

Otherwise, if, for example, you put all your capital in only one asset class like bitcoin, you risk losing your entire investment if this asset crashes. 

But if you put small percentages of your capital into ETF, mutual fund, stock, bond, and commodity assets, you will have reduced market risk even if one of these assets defaults.

To decide which asset classes to invest in, consider your investment goals, preferences, and risk appetite. 

3. Derivatives

Derivatives are financial instruments that help you hedge your investment in two ways:

Forward Contracts 

Forward contracts allow you to sell or buy an asset on a future date at a specified price. 

You might opt for this hedging strategy if the asset of your interest is experiencing price volatility or if you expect something might affect the supply and demand of the asset. For example, if you predict that there will be a shortage of oil soon, you can buy forward contracts now at a lower price so you can, later on, sell the asset at a higher price.

Futures Contract and Options

Futures contract and option derivatives work similarly to forward contracts - they give you the right to buy or sell an asset in the future at a pre-set price (determined in terms of the underlying asset.) 

However, futures contracts and options are more tightly regulated than forward contracts, and you’ll have to keep them for the full contract duration.

4. Pairs Trading

This common risk management strategy involves pairing long and short positions in two stocks with a long-term positive correlation. 

To successfully adopt this strategy, you need to identify a discrepancy in the correlation (usually, this is a short period in which one of the assets is overvalued and the other is undervalued.) 

Once you identify such faltering, the pairing trade can be implemented. This involves going long on the undervalued asset and short selling the overvalued asset. 

Due to its complexity, this strategy is usually not practiced by beginner individual investors.

5. Arbitrage

This is a very simple but effective hedging strategy, most commonly used in the stock market. 

You buy assets in one financial market and immediately sell them in another one at a higher price. This way, you secure small but stable profit increments that accumulate over time. 

6. Spread Hedging

This is a common strategy among options traders. It is usually adopted when investors expect the price of an asset to decline. To offset the losses, they buy a put at a higher strike price and sell a put at a lower price but with the same expiration date.

The profit you can make from this investment strategy is the difference between the two prices minus the cost of the operations. This is considered to be a good hedge against short-term index declines.

7. Average Down

This strategy involves buying more shares or units of an asset you already own after selling prices have decreased. This way, investors reduce the average cost of their purchased stocks to offset losses. 

For example, if you purchased 10 shares for $20 per share, and now the share price drops to  $10, you can buy 10 more shares at the lower price to hedge against any potential loss (if you won’t be able to sell the shares at a price high enough to make a profit.) 

This way, the average price of your shares will go down to $15 per share, and the profit from the lower-priced assets will make up for the losses of the higher-priced assets.

This is a good investment strategy if you plan on holding to your assets in the long term.

8. Delta Hedging

Delta hedging is a more complex risk management strategy mainly used by accredited investors and investment banks. 

Delta is an options trading measure that shows how much an option’s price will change given a $1 move on its underlying asset.

This method involves neutralizing (achieving a “delta neutral” state) or reducing the change of an option’s price in relation to the asset’s price. The main disadvantage of this strategy is that it requires constant observation and adjusting of your positions, which is time-consuming and comes at an additional trading cost. 

9. Hedge Funds

A hedge fund involves adopting complex investment strategies to achieve a return on investment higher than the average. 

Hedge funds are not as heavily regulated as mutual fund establishments. The hedge fund is controlled by a portfolio manager who is paid a portion of the returns (so if the fund makes no profit, the portfolio manager would not receive any payment.) 

While such funds are highly risky, they’re also used by some institutional investors and traditional funds to put a portion of their capital into a hedged bet. 

For example, suppose you’re an accredited investor with a portfolio of cyclical assets. In that case, you might want to invest a portion of your money into a hedge fund that pursues only non-cyclical assets. So, if the economy tanks, your hedge fund investment will offset the losses in your portfolio.

10. Staying in Cash

You might want to keep some of your assets in cash. This prevents you from any investment losses. However, keep in mind that this hedging strategy is unsuitable during inflation since your cash can devaluate substantially.

Let’s take a look at the main pros and cons of pursuing any of these hedging strategies.

Hedging: Advantages and Disadvantages

Adopting hedging strategies can help you:

• Minimize losses
• Protect you from inflation, recession, foreign exchange risk, and market volatility
• Increase portfolio liquidity 
• Diversify your portfolio

However, hedging also has some disadvantages like:

• It’s not 100% risk-free.
• It helps reduce losses, but it rarely results in substantial profits.
• It does not guarantee future success.
• It requires constant analysis and monitoring of the financial market fluctuations.

Other FAQs on The Best Hedging Strategies 

Now, let’s take a look at the answers to some other questions you may have:

1. What is the Best Hedging Strategy?

There is no universal hedging strategy that can be categorized as the best one. While some strategies might work well for some investors, they might fail for others. Whether a strategy is successful for you depends on your investment goals and financial risk tolerance. 

Choosing the right hedging strategy also depends on the asset’s downside risk. Also, the higher the downside risk, the higher the hedge cost.

To identify the best strategy for you, you need to research all the options and understand which strategy will suit your needs best.

2. Who Uses Hedging Strategies? 

While any investor can use hedging strategies, applying them effectively requires in-depth knowledge of the markets and the ability to forecast accurately future economic changes. So, such strategies are usually used by institutional investors and retail traders.

3. Which Markets Benefit from Hedging Strategies?

The markets in which hedging strategies work best are:

• Commodities: This includes the energy, oil, metal, and farming industries.
• Currencies: Involves foreign currency with high market volatility and currency risk. Currency hedging helps investors reduce the foreign exchange rate differences.
• Interest rate markets: Involves fluctuating lending and borrowing interest rates (the risk associated with the interest rate is called interest rate risk.)
• Securities: This market includes different equities, shares, and indices.

4. What Is De-Hedging?

De-hedging involves exiting a current hedging position. The reasons for that could be:

• Hedging is no longer needed.
• Implementing a hedging strategy is too costly and negatively impacts your cash flow.
• The investor is willing to pursue high-risk investments.

Choose The Best Hedging Strategy For Your Portfolio

Hedging is a good way to reduce market risk. To implement hedging effectively, you need to choose a suitable strategy and have in-depth knowledge of the market you’re investing in. 

One of the simpler hedging strategies is investing in safe-haven assets like gold and wine since these preserve their value and can offset the losses of any of your more volatile assets.

To start your wine investment journey, just sign up on Vinovest and start building an enviable wine portfolio!