For Investors: 6 Risk Management Methods Through Hedging in the Stock Market

In the context of an unusual market volatility caused by macroeconomic factors, protecting your investment portfolio is not an option but a necessity. Hedging (risk mitigation) is a technique used by traders employing derivative instruments to minimize potential losses. Those who master hedging methods will have a better ability to protect assets and maintain stable performance across market cycles.

What Is Hedging and How Does It Work

Hedging is a financial term referring to the use of protective tools such as futures contracts, options, or CFDs to counteract unexpected market fluctuations. The essence of hedging lies in opening positions that have an inverse correlation with your current assets.

A real-world example from 2022: when geopolitical tensions between Russia and Ukraine suddenly increased, the stock market entered a state of uncertainty. If your portfolio holds long (buy) positions in stocks, an effective hedge is to create short (sell) positions in certain assets or indices with high correlation. When risks materialize, profits from the short position will offset the losses from the long position.

However, the difficulty in applying hedging lies in correctly identifying pairs of assets with inverse correlation. Without careful consideration, both positions could suffer losses simultaneously, undermining the original strategy.

###Advantages and Disadvantages of Hedging

Common Hedging Tools and Their Features

The market offers various tools for hedging, each with unique advantages suited to different risk levels and asset scales.

Derivative Instruments (Futures, Options, CFDs) - High cost, used when potential risks are significant and can lead to strong volatility. Suitable for all asset types from commodities to forex.

Portfolio Diversification - Low cost, suitable when potential risks are not too high. Includes safe-haven assets such as gold, government bonds, and defensive stocks.

Long - Short Strategies - Moderate cost, suitable for short-term risks and assets with high intraday volatility like forex or cryptocurrencies.

Using CFDs in Hedging Strategies

CFD (Contract for Difference) is a popular tool because it allows trading without owning the physical asset. An investor long on AAPL might worry about the impact of FED interest rate hikes leading to inflation. Instead of selling the stock, they can buy a CFD on gold to hedge without storing physical gold.

###Two Ways to Apply CFDs for Hedging

Method 1: Long - Short Index Instruments

You hold $1,000 worth of Tesla stock but forecast inflation will rise, causing the NASDAQ index to fall. You decide to Short CFD NASDAQ with $10 (leverage of 1:200) to protect your portfolio.

Results from October 2021 to present:

• TSLA down -15.68%, losing $156.8
• Short NASDAQ up 3,808%, earning $380.8
• Net result: +$224 profit

Method 2: Long Safe-Haven Assets

Hold Tesla stock but Long CFD on gold with $10 (leverage of 1:100). Gold increased by 7.36%, earning $73.6, partially offsetting Tesla’s losses, reducing overall portfolio loss to -$83.2.

###CFD vs. Futures Contracts

CFDs are suitable for retail investors due to low capital requirements, flexibility in terms, and ability to trade across multiple platforms.

6 Comprehensive Hedging Methods for Stock Portfolios

( 1. Short Selling Derivatives

When uncertain about imminent risks but unwilling to lose existing long positions, short selling CFDs, futures, or options on indices or stocks that are likely to decline rapidly is the simplest approach. As in the NASDAQ example above, the short position fully offset the losses.

) 2. Hedging with Forex

The US dollar ###USD###, Swiss Franc (CHF), and Japanese Yen (JPY) are called “safe-haven currencies.” During the Russia-Ukraine tensions in 2022, USD appreciated sharply as it was considered a safe asset. The inverse correlation between stock indices and USD strength makes long positions in USD-related forex pairs an effective hedging strategy against political risks.

( 3. Building a Diversified Investment Portfolio

Owning assets with low or inverse correlations helps reduce overall volatility. Stocks and gold often move inversely. For example, investing in S&P 500, adding forex and bonds to the portfolio can lower overall risk due to their protective properties.

) 4. Holding Cash as a Defensive Measure

Cash is a sure way to hedge risks. When volatility occurs, all financial assets tend to fluctuate. A portfolio with a high cash ratio will suffer less damage during market crashes.

5. Investing in Inverse ETFs ###Inverse ETF###

These are newer tools designed to generate returns opposite to an underlying index. They operate using short selling, futures, and leverage techniques. When the market declines, Inverse ETFs increase in value. The advantage is that they can be traded on regular brokerage accounts, but careful verification is needed to ensure they closely track the underlying index.

( 6. Buying VIX Index )VIX###

The Volatility Index (VIX) rises during market crises. You can buy VIX futures, ETFs, or options based on VIX. Since volatility often spikes during market corrections, these instruments increase in value when long stock positions lose value. Buying volatility ETFs when VIX is at historically low levels is an effective risk mitigation method.

Conclusion

Political risks and policy changes are factors beyond any investor’s control. Therefore, what is hedging? Essentially, it is a tool to survive difficult market periods. Although hedging may reduce profits in favorable market conditions, it provides valuable protection when risks materialize.

However, not all hedging strategies succeed. If risks do not occur, you will incur losses from the hedging positions. Therefore, to make hedging truly effective, it must be tested and validated through practical experience and various methods before fully implementing it into your actual portfolio.