Examples of hedging in trading

    Diversification - The oldest and most well-known form of hedging is simple diversification. By buying a variety of different financial assets, your portfolio is not tied to any one security or industry. If tough times hit automakers and you hold GM and Ford, a portfolio balanced with technology and banking stocks could offset the losses from auto stocks. Target-date funds are great examples of reducing risk through diversification.

    Covered Call Options - A covered call is when you buy a stock while writing call options on the same stock (i.e., selling). If you buy ABC stock with the goal of long-term price appreciation, you may experience flat trading periods in which the stock fluctuates within a defined range. If you expect this trading range to continue, you can sell a call option on the stock that provides income while your stock is trading flat. Note that this strategy can backfire during periods of high volatility, but using covered calls is one of the most common forms of hedging with options.

    Out-of-the-Money Put Options - To protect stock holdings against an unknown negative event (or black swan), some traders choose to buy long-dated put options with a strike price well below the current stock price. These put options are attractive because they are cheap but almost always expire worthless. Unlike covered calls, out-of-the-money put options only save money if there is a serious market correction. Much like buying a "catastrophic" health plan, this strategy is cheap insurance against the worst case scenario. Just understand that you will spend 99% of your trading time bleeding profits out of the money with put options.

    Hedge with commodity futures - Many industries depend on cheap commodities to keep prices low or profits high. When oil prices are low, airlines can fuel their jets cheaply. When the price of coffee skyrockets, Starbucks and Dunkin Donuts have to raise the price of their drinks at the same time. When companies have this kind of relationship with a tradable commodity, investors can use it to their advantage. If a trader holds shares of Southwest and Delta Airlines, he can hedge those holdings by buying oil futures. If oil prices rise rapidly, the airlines' stocks will come under pressure due to increased fuel costs, but the trader will make money with exness.

My summary on hedging

If a trade turns against you, a properly placed hedge can prevent you from losing most of your investment. But remember that hedging also comes with drawbacks and inconveniences.

When you hedge a trade, you must buy a security that moves in the opposite direction of your original investment. Not only does this lower your maximum profit level, but you also pay transaction costs for two trades instead of one.

Hedging a trade is buying insurance

And like auto and health insurance, you need to decide what level of protection is right for you. Do you want to protect your assets with full coverage auto insurance or risk buying only state minimum coverage?

And likewise, do you want to just run your trades or do you want to take something off the top to preserve your assets? It's a personal decision - there's no right or wrong answer.

Just make sure you understand the pros and cons of hedging before adding it to your trading toolkit.