CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 75.00% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
Galt and Taggart rightly predicted that 2023 would be a year of high volatility. This was mainly due to the continued monetary tightening in developed economies, clubbed with promising growth in the emerging markets, which created inflation divergences. The mid-year outlook by JP Morgan highlighted that the inflation psychology of both policymakers and investors was shifting and the market volatility index (VIX) would remain at around 25.
As inflation cools, increased trader activity will likely induce more volatility in the financial markets. This means stronger analysis and hedging of positions to navigate the uncertain market.
Traders often suffer due to false alarms. They either trigger risk protection measures too early or delay them until losses have accumulated. Hedging empowers traders to exercise more control over their portfolios beyond risk management. This is because they actively take positions to mitigate risks associated with previously opened positions. A reduction in the potential for losses helps traders maintain a rational trading psyche. Traders also use hedging as protective insurance to diversify high-risk portfolios and avoid tax implications that may arise on closing positions.
Traders need to align their hedging strategies as their trading strategy evolves and market conditions change.
Beginners prefer to keep their hedged positions fixed, since they trade a limited set of assets, often involving similar market behaviour.
Experienced traders dynamically increase or reduce their hedge position sizes and even include or exclude assets to maintain a consistent and effective hedge ratio. Irrespective of the hedging technique, ensuring hedge efficacy is essential. Quantifying managed and unmanaged risk and the efficiency of hedging can help provide a clearer picture of expected portfolio performance.
The first step is to pick the most suitable instruments for hedging, based on your trading strategy.
Modern Portfolio Theory (MPT) describes diversification as the most effective way to manage risks associated with volatility. The theory suggests that you statistically evaluate the expected returns for a defined amount of risk. It uses the correlation between assets to determine effective fund distribution and create a balanced portfolio.
This is popular among stock traders. Traders purchase more shares of a stock that has recently declined and incurred losses. As the market corrects and the price rises, the gains offset the loss from their initial position.
Some instruments are considered safe havens during market uncertainties.
Traders identify assets that are negatively or poorly correlated. One of them is undervalued, and the other is overvalued. They hedge against price fluctuations relying on the market’s tendency to correct itself. They do this by opening long positions on undervalued assets and short ones on overvalued assets.
Derivative instruments allow traders to amplify potential gains. CFDs are a popularly traded instrument that do not require you to own the underlying asset. Traders speculate on price movements, and the settlement involves only the price difference between the contract’s opening and the date of closing.
A popular strategy is to open a large position toward the expected price movement. Simultaneously, a smaller position in the opposite direction works as a hedge. If the markets move in the opposite direction to the speculation, the losses in the larger position are offset by gains in the smaller one. However, remember to use leverage carefully because it also multiplies loss potential.
Cryptocurrencies have gained much attention due to their outsized returns. More recently, traders are increasingly making space for digital assets in their portfolios to hedge against the risks of trading the traditional financial markets.
Based on the assets in your portfolio, identify the risks you wish to hedge against, such as currency fluctuations or commodity price movements.
Once the risk is identified, set your hedging objectives to limit risk exposure according to the size of the position and the degree of risk associated with it.
Pick the most suitable hedging instruments and strategies while maintaining portfolio growth and limited losses.
Learn to determine the hedge ratio to gauge the efficacy of your hedging plan.
Implement and monitor the plan to retain portfolio growth as the markets move. Tweak the portfolio if required.
Experienced traders consider their risk appetite, risk tolerance and available capital while developing hedging strategies. A few things to keep in mind are:
The key to building an efficient hedging plan is identifying a comfortable level of risk exposure that ensures portfolio growth and peace of mind.
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