Unfortunately, risk is an unavoidable part of life. Whether you’re buying a house or jumping out of an airplane, you assume some degree of risk. In the world of finance, active hedging is like a skydiver’s parachute ― when properly used, catastrophe may be routinely averted. Let’s take a look at three ways of making sure your hedge exposure is optimized and your chute opens.
Know Your Risk
Merriam-Webster defines the term hedge as being “a means of protection or defense.” When it comes to money, this equates to taking an offsetting position in a related asset or derivatives product. Subsequently, a hedger assumes a degree of security at a specified cost.
It may sound like an elementary point, but in order to properly address risk, you must first know which dangers are imminent threats. Here are a few elements of risk that must be quantified in order to successfully manage hedge exposure:
- Type: When crafting a hedging strategy, the type of risk in question matters. Different approaches will be necessary to adequately address financial, systematic, or producer risks. Understanding which are most applicable to your specific situation is a critical first step in addressing potential hazards competently.
- Duration: Anytime asset pricing and money are involved, time is an important factor. Being aware of investment horizons and capital allocation schedules are essential.
- Unknown Unknowns: In many facets of life, attempting to account for unidentified risks (a.k.a. “unknown unknowns”) is a fruitless endeavor. Nonetheless, when it comes to developing a strong hedge, it pays to take time out and consider as many negative scenarios as possible.
Understanding the type of risk, time horizons, and potential unforeseen hazards are integral parts of building a finely tuned defensive hedge. Through a bit of education, scheduling, and brainstorming, it’s possible to mitigate a large percentage of risks before they become dangerous.
Account for Counterparty Risk
Depending on the type of market and transaction you’re entering, counterparty risk may or may not be a pressing issue. However, it’s important to at least understand the basic concept and how it relates to hedge exposure.
Counterparty risk is the probability that a participant in a transaction will default on contractual obligations. While not an overwhelming issue in regards to exchange-traded futures and options contracts, some instruments such as credit default swaps carry a higher counterparty risk.
If you’re actively hedging via futures and options, counterparty risk may be greatly mitigated by simply investigating your broker. Finding a competent brokerage service that is licensed, reputable, and in good financial standing is a worthwhile endeavor, and it’s relatively straightforward.
The world markets are dynamic atmospheres, constantly changing in response to a vast array of stimuli. To ensure that your hedge exposure is maintained at acceptable levels, regular evaluations are necessary. A good place to begin this process is to address the following questions:
- How is the hedge performing? Subpar performance can be a signal of an inadequate hedge. If “locked in” profits are inexplicably deteriorating, further review is warranted.
- Am I ignoring any risks? Are the unknown unknowns undermining performance? If so, addressing them as quickly as possible is vital to correcting the problem.
- Are there any potential game-changers on the horizon? Elections, armed conflicts, or geopolitical tensions can upend almost any market, from corn to crude oil. If uncertainty is likely to dominate the markets, then your hedging strategy needs to be reevaluated.
Sometimes a risk management plan must be amended to bolster performance. Fortunately, futures afford participants the flexibility to change direction quickly to adapt to current market conditions.
Optimize Your Hedge Exposure
If you’re new to hedging, then concepts such as risk types and counterparty defaults may appear a bit mysterious. Fortunately, modern investors have a wealth of resources at their fingertips to help flatten the learning curve.
A great place to learn more about hedging and risk is at the online educational suite offered by Daniels Trading. This collection of blogs, trading guides, and webinars is available absolutely free, 24/7/365.