One of the most imperative elements of investing, having the proper portfolio protection can literally make or break your investment efforts. A concept that is seldom fully understood by those outside of the financial sector, the notion of hedging, or diversifying your portfolio in order to reduce your investment risks, is often the most important part of obtaining and maintaining one’s investment portfolio. Widely considered the best method of reducing the risks associated with investing one’s money, risk management is a term that every investor should be familiar with.
Options, Derivatives, and More
For those who are yet unfamiliar, derivatives are a form of security for investments that are based on one or more underlying assets, exist in the form of a contract between two or more parties, and whose value is determined by the fluctuations of said asset or assets. The most common assets utilized for derivatives being, commodities, currencies, stocks, and bonds.
In keeping with that notion, derivatives with options involve signing a contract being sold by one party (the option writer) to another party (the option holder). By offering the right, not the necessity, to buy or sell a security, or any other type of financial asset at a mutually agreed upon price (known as the strike price) during a certain agreed upon time span or by a specific date (known as the exercise date). Call options (buying options) gives the option to buy at a certain price, therefore, the buyer would be waiting for the price to go up. On the flip side, put options (selling options) give the option for buyers to sell at a certain price, therefore, the buyer would be seeking a decreased price.
In short, hedging is essentially investing in options. The best method for those who may not yet be sufficiently financially literate, this is a great way to address the risk factor associated with investing. One of the most common options for hedging being, the ability to utilize derivatives to offset potential losses when investing in risky stocks. Thus, new buyers can have more confidence in taking more risky investments as potential losses can be offset by derivatives, by giving buyers the option to sell said stocks at the agreed upon “strike price”.
Another potential way to employ the hedging process involves businesses that depend heavily on stable prices of a particular commodity. In order to hedge against an unforeseen skyrocketing of prices, the business could enter into a futures contract which would allow the business to buy the commodity at a set price, on an agreed upon date in the future. This is a great method for small or big business owners who have a company based on the usage of a specific commodity.
Overall, taking risks is the most important element of investing. The phrase “high risk, high reward” is especially true when dealing with the matters in the financial sector. With that said, learning more about risk management, hedging, and derivatives are a great way to minimize the risk of investing. Regardless of how seasoned one may or may not be in terms of investing, learning the importance of risk management can save you tons of time and money.