This can cloud your judgment, which as a trader or investor it is imperative to think with a clear head. When you are placing the hedge, it is set at a logical point that is determined without emotions. This increases the chances that you have reduced your risks by eliminating the emotionalism that accompanies the markets. (Carr, 2002)
Another reason why hedging is effective, is it allows you to protect your downside using as little working capital as possible. Because hedging involves using options, means that the overall amounts of upfront costs are low. This means, that going into the hedge you know what your maximum down side will be (the premium). You can also reduce the amounts of risk by purchasing the options with expirations that are coming up, within the next 30 to 60 days. This is important, because the closer the option moves to the expiration date, the less it becomes. When you are hedging, you can purchase some of these cheaper options, protecting your downside as much as possible. While reducing, the amount of working capital you are investing in the hedging strategy. (Carr, 2002)
Clearly, hedging is an effective way of being able to reduce the overall amounts of risk for a portfolio or position. It has been used for a number of different investment classes to include: forward contracts, options, insurance policies, futures contracts, stocks and swaps. This is important, because it gives both investors and traders a way of reducing the overall amounts of risk as much as possible. However, like all investing hedging does involve its fair share of risks, the most notable would be: the pricing and timing of the hedging strategy. This is because, to make the hedge as effective as possible...
When a reversal takes place from this, is when the effectiveness of the hedging strategy will be brought into to question. This is similar to what happened with Southwest Airlines in 2008, when they failed to see a decline in the price of West Texas Light Sweet Crude, despite the fact that oil was at an all time high. This decision would force the airline to see its first loss in 17 years. Yet, hedging has been proven to be effective when the emotionalism has been taken out of the markets and by reducing the amounts of working capital to achieve this objective. These two factors are important, because they highlight how this strategy can be used by traders and investors, to reduce the overall amounts of risk as much as possible. In world where the markets are facing increasing amounts volatility, this strategy can provide a way of effectively reducing losses. Like all other investment strategies, hedging does have it fair share of risks. It is through weighing the risks vs. rewards that will help you to decide if hedging is right for you.
Bibliography
Carr, P. (2002, October 1). Static Hedging of Standard Options. Retrieved February 27, 2010 from Fordham
University website: http://www.bnet.fordham.edu/crif/WorkingPapers/crifwp02010.pdf
Maynard, M (2008, October 1). Southwest Has First Loss in 17 Years. Retrieved February 26, 2010 from New York
Times website: http://www.nytimes.com/2008/10/17/business/17air.html?_r=1
Sooron, C. (2009). What is Hedging? Why Do Companies Hedge. Retrieved February 27, 2010 Finpipe website:
http://www.finpipe.com/hedge.htm
