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Peter DeCaprio explains the process of hedging as a risk management tool during trading

Peter DeCaprio

Investors in the stock market have a dual goal – protect their investment and make profits. Although these goals are complementary, the methods are different. According to Peter DeCaprio, it is vital to protect the investment first by managing risks so that investors get the opportunity to make profits.

Follow the one percent rule

The most common risk management technique when trading the stock market is to follow the one percent rule, which says that you should not put more than 1%of your trading account or trading capital into a single transaction or trade. The rule helps to avoid over-investing in a single trade which automatically restricts the losses. However, you can be a little adventurist and raise the investment to 2% but not beyond it. Exceeding the limit will increase your risk substantially.

Hedging protects your portfolio

Hedging is the other risk management technique popular among stock market investors to protect their portfolios. Although most investors frequently hear about hedging, many people do not adequately understand the method, except that it helps offset losses in investments by taking a position opposite to the asset in question.

What is hedging?

Hedging is the technique of protecting an investment similar to the protection offered by insurance, explains Peter DeCaprio.  When you decide to hedge, you are insuring yourself against the impact of an adverse event on your finances. Although hedging is not a deterrent for adverse events that can still happen. It negates or diminishes the event’s negative impact by insulating your finances.  The technique of hedging applies across the financial sector and not the stock markets alone. The most common example of hedging is taking homeowner’s insurance that protects the property from unforeseen dangers like fire, thefts, and other damaging events.

Hedging in the financial market

Hedging techniques are useful for individual investors, portfolio managers, and corporations to mitigate the risks to various exposures. However, the technique of hedging in the financial markets is not as simple as buying an insurance policy.

Hedging in the context of the stock market is a pretty different and complex exercise by using various tactical tools available in the market to take care of the risk of any hostile price movements. In simple words, investors in the stock market who take to hedging make another investment to hedge the targeted investment. Investors who want to hedge would invest in two securities. That share negative correlations by paying for it in one form or another.

Hedging does not help eliminate the risks and pave the way for high profits. Instead, the approach reduces potential risks, which translates into a reduction of profits too. Therefore, hedging helps mitigate potential losses, and in no way does it help make money as many might think.

Think about the cost

To decide whether hedging would benefit you. Consider the cost involved in the process, which should be less than the benefits derived from hedging. Only when you see that there is an upside can you go for hedging.

Analyze the situation and consider the factors that affect your investment to decide whether hedging would be suitable for that moment.