7 strategies for financial hedging

Hedging is the practice of opening multiple positions at the same time in order to protect your portfolio from volatility or uncertainty within the financial markets. This involves offsetting losses on one position with gains from the other.

Typically, the aim of financial hedging is to take a position on two different financial instruments that have an opposing correlation with each other. This means that if one instrument declines in value, the other is likely to increase, which can help to offset any risk from the declining position with a profit. These investment decisions should not be rushed and require a lot of thought and analysis beforehand.

Financial hedging is perhaps more common amongst short-term​ and medium-term traders, as market volatility tends to last for limited periods of time and these traders aim to take advantage of rapid price fluctuations. Long-term position traders are less likely to take into account recent changes within the market and instead, they more often open positions based on their predictions for the long-term future.

Hedging strategies are commonly used by retail traders that have a good knowledge of the financial markets and are able to forecast upcoming changes within the economy. However, anyone can use a hedging strategy, especially if there is a large sum of money or portfolio involved. For this reason, professional traders and institutional investors also tend to apply this strategy.

Hedging can be seen as a risk-management strategy that helps to protect your trading portfolio. Trading in volatile markets can present consequent risks for an investor: changes to interest rates and currency exchange rates, political, social and economic instability, geographical changes, and commodity shortages, to name a few. These are all factors that a trader could consider as part of their fundamental analysis​ before opening positions. This way, they are able to plan their hedging strategies in advance of the markets in order to minimise losses.

Hedging strategies come in many forms, depending on the financial market and instrument that you are looking to trade. Here are some of the most common approaches that traders tend to use:

Pairs trading is perhaps the most commonly utilised method of hedging. The best way to describe pairs trading is essentially as a long-short hedge strategy, meaning that it’s market-neutral. It doesn’t matter if the two securities involved belong within the same asset class, as long as there is a positive correlation between them.

In order to carry out a pairs trading strategy, the trader should identify when one asset is overvalued and one is undervalued, where their deviating values are calculated using the standard deviation​. They can then choose to open a buy position to go long on the asset that is undervalued, and short sell the overvalued position. In order to make a profit, the assets should reverse back to their original positive correlation.

Learn more about pairs trading​​.

Asset allocation is another strategy that aims to offset risk while also diversifying your trading portfolio​. For example, some traders choose to dedicate a certain percentage of their portfolio to separate asset classes, such as 40% equities and 60% bonds. This allocation depends on many factors and characteristics of the trader, such as age, investment goals and risk appetite, so we would never recommend the same strategy for every trader.

An effective way to spread out your asset allocation could be to add indices, share baskets or ETFs to your portfolio, which contain multiple stocks using one single position. This ensures that your risk is spread across a number of assets that have the potential to rise or fall equally, rather than placing your entire capital on one potentially risky asset.

Browse a number of different asset allocation strategies​.

Let’s explore how to utilise financial hedging in the stock market as part of a CFD trading strategy​ for a shareholder that already owns company stock from elsewhere. Please note that we don’t currently offer shareholding services to our clients in the UK.

Investor responses to potential volatility depends on their individual circumstances and approach. For active investors, the risk-averse, and those with concentrated holdings in a single stock, hedging may be a viable option.

Naturally, there are costs involved in establishing the CFD position.

Margin required: establishing a long or short position in CFDs requires an initial margin. This is usually in the range of 5% to 20%, depending on the size and liquidity of the stock, making CFDs a more capital efficient form of hedge.

Holding costs: holding a position overnight will result in overnight fees, although if the CFD position is open for just a few days, these are likely minimal. (Please note that forward contracts don’t have any overnight holding fees).

Tax consideration: these are dependent on individual circumstances but CFDs usually require you to pay capital gains tax, although they are exempt from stamp duty*.

Before carrying out a hedging strategy, you should try to calculate whether the risk-reward ratio​ is worth it; in other words, whether the amount you pay to open multiple positions will supersede the losses saved on a particular trade.

Hedging strategies can also be practised with a spread betting account, which is tax-free but, similar to CFDs, also comes with spread costs and overnight fees, as well as others. Read an overview of our trading costs for each product.