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Tuesday, March 10, 2009

Advantages and Disadvantages of Hedging

Like any other wealth-building practices, hedging involves both benefits and drawbacks. These benefits and pitfalls differ with trading style, investment preferences, market changes, other risk-minimizing practices and trading goals. In short, the benefits that one gets from hedging his risks can be not there for other trader.

Advantages of Hedging
  1. Hedging using futures and options are very good short-term risk-minimizing strategy for long-term traders and investors.
  2. Hedging tools can also be used for locking the profit.
  3. Hedging enables traders to survive hard market periods.
  4. Successful hedging gives the trader protection against commodity price changes, inflation, currency exchange rate changes, interest rate changes, etc.
  5. Hedging can also save time as the long-term trader is not required to monitor/adjust his portfolio with daily market volatility.
  6. Hedging using options provide the trader an opportunity to practice complex options trading strategies to maximize his return.
Disadvantages of Hedging
  1. Hedging involves cost that can eat up the profit.
  2. Risk and reward are often proportional to one other; thus reducing risk means reducing profits.
  3. For most short-term traders, e.g.: for a day trader, hedging is a difficult strategy to follow.
  4. If the market is performing well or moving sidewise, then hedging offer little benefits.
  5. Trading of options or futures often demand higher account requirements like more capital or balance.
  6. Hedging is a precise trading strategy and successful hedging requires good trading skills and experience.

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