How to hedge risks using futures contracts

Hedging risks with futures. Not only major companies but also traders and investors should think about it. Hedging is insurance, which is available to all. Read in the article:

• What is hedging?
• Advantages of hedging.
• Difference between diversification and hedging with futures.
• Hedging with futures.
• Conclusions. What to do in practice?

What is hedging?

The goal of hedging in the financial markets is protection of investments. Hedging is an investment method, which is directed at reduction of possible losses. Instruments, which do not correlate with each other, can be used for hedging. A hedging example from everyday life is purchase of an automobile insurance policy. Insurance can cover a part of possible losses in the event of a car accident or damage. The same approach is applied in the financial world. Hedge funds, investment funds and private traders actively use hedging for reducing various risks. Hedging cannot protect from losses completely, but can reduce them. It is possible to hedge various markets and events:

• Stocks. The stock market is actively used for investing in individual stock, stock portfolios and stock indices.
• Commodities. Oil, gold, silver, wheat, coffee and so on are important commodities in the world economy, and it is important for many companies to hedge their price fluctuations.
• Interest rate market. This field includes lending and credit rates, and respective risks.
• Currency market. This field is connected with investing in currencies of various countries (we have an individual article about hedging currency risks).
• Weather. It is possible to hedge even weather risks, which can be interesting for agricultural producers.

Risk hedging is an important part of the modern business and economy, that is why it is important both for companies and private traders and investors to master basic hedging principles.

Advantages of hedging

Hedging is getting more and more popular, that is why new derivative instruments, which help to control risks, emerge all the time. Various financial derivatives are used for hedging:

• Forward contracts.

• Futures contracts. Here’s the list of some agricultural and energy futures available for hedging in the trading and analytical ATAS platform:

• Options.

• ETF.

Other more complex financial instruments. Hedging risks with futures is a very popular method. Many professional investors and traders use futures hedging against potential falls in the market. For example, they can try to protect or secure their portfolios against so-called black swans. These can be unforeseen events in the market, such as a financial crisis, an unexpected election result, natural or man-made disasters. Such events can result in a significant fall of stock prices, a protection against which futures hedging can be. Individual investors can also use hedging through various stock index futures. Such an approach can protect individual investor portfolios against excessive volatility and falls in the market.

Difference between diversification and hedging with futures

In order to understand the difference between diversification and hedging, first of all, it is important to discuss what risks an investor can face. In fact, you expose yourself to a risk when you buy a company stock. Actually, there are two types of risk:

You can select the following futures from this list:

• Australian Dollar,
• British Pound,
• Canadian Dollar,
• Euro Fx,
• Japanese Yen,
• Swiss Franc.

You can leave the seventh part of your portfolio in USD on your account. It is preferable to buy futures at their full face value without using leverage, since the goal of such a portfolio is to protect your funds. If you have a small account, you can use micro futures or only a part of currency futures. You can buy other currency futures while your deposit grows. You will need to track contract expiration dates. When a contract expires, you will need to buy another contract, however, it doesn’t happen often. Such a portfolio, which consists of currency futures of various countries, can hedge any currency devaluation risks properly. In fact, you can keep your savings in a basket of seven basic world currencies. And how to select the most successful entry point? The trading and analytical ATAS platform can also help you in it. Use the daily futures chart for it. Let’s consider an example of the Japanese Yen futures (6J) chart with the TPO and Profile indicator with the monthly period. This indicator is good at showing volume accumulation for the past month.

The picture shows the month’s closing price above the month’s maximum volume level. Most probably, the major player’s buys pushed the price up, so there was a probability of the up movement continuation. This situation represents a good opportunity for buying Japanese Yen futures for your currency portfolio.

Conclusions. What to do in practice?

Hedging risks with futures is what major companies and rich people do, that is why it is important for a private trader and investor to:

• study instruments available for hedging;
• study strategies, which are used for hedging risks with futures;
• use a currency futures basket for hedging their own currency risks;
• use the trading and analytical ATAS platform for identifying optimum entry points.

Insurance protects against risks in everyday life and futures hedging protects against risks in the financial markets. Use this instrument!