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posted on 01 September 2016

What Is Hedging

by Brandon Wendell, Online Trading Academy

Online Trading Academy Article of the Week

Investors have one thing in common; they are seeking out the best possible returns for their capital. Often though, they do this while taking unnecessary risks or risks that do not justify the size of returns they are receiving. The average return on the S&P 500 per year for the last 20 years is a little over 9%. How many of your retirement accounts attained even that?

Traditional, financial advisors suggest that you should trust them for your financial planning, and that if you are placed in the right investments your money will grow. They recommend that you do nothing when the markets drop and just wait until they recover to enjoy the returns over time.

This may work if you have a long period of time until you retire, but what about the tens of thousands of baby boomers who saw their retirement accounts diminish by more than 40% in the 2008 crash? They had to postpone retirement for many years and perhaps even missed out on being able to increase their returns while sitting out.

I am not suggesting that you actively trade your retirement accounts. After all, leaving your money in a good investment is going to net you positive returns and keep your commission and other costs low. However, there are two simple things you can do to improve your ability to retire when and how you want to. First, you need to ensure that you do have your money in the correct vehicles to maximize your returns. Secondly, when the markets do turn bearish, don't panic, try hedging instead!

Choosing the Right Investment Vehicles

Looking at the first concept of correct investment vehicles, most financial advisors get paid not just from commissions they charge for transactions but by the companies who offer the products they place your money into. This is not commonly known by most people who invest in their company 401k or an IRA. A mutual fund is the best example. As long as you keep your money in the fund, the broker receives a payment from the fund company. This reduces your returns dramatically over your investment period.

I am not accusing all financial advisors of steering you into these investments because of their ability to receive compensation over your financial well-being, but it is a major temptation, and the way the industry has been operating for decades. Asking your advisor to switch from a mutual fund to an Exchange Traded Fund could save you tens of thousands of dollars over the years!

Look into other asset classes as well. Most people are happy buying stocks and funds because that is what they are familiar with. Becoming educated in other assets like Forex (currency), Options or Futures offers you the ability to increase your returns from the leverage provided by these investment vehicles. Many brokerages do have IRA and 401k accounts that allow you to invest in them.

Looking at Forex, there is a simple concept called the carry trade. This is something that most financial institutions and even governments will do to receive easy returns on capital. When you enter into a Forex trade, you place money into a margin account. The broker then lends you a larger sum of money which you can use to buy another currency with. This is similar to exchanging your money for another currency when you travel internationally. If the currency you buy goes up in value, when you buy back your original home currency you profit as you will receive the increased value back.

The other factor you need to consider is that when you borrow money you have to pay interest. But if you buy a currency from a country that has a higher interest rate, you receive the difference in the interest!

Take for example the New Zealand Dollar versus the US Dollar. One lot (a lot is what you trade instead of shares) would require a margin deposit of $1600. Your broker would lend you approximately $73,000 in order for you to buy $100,000 of New Zealand Dollars. You must pay about 0.5% interest annually on the $73,000 you borrowed, but would receive about 2% interest annually on the $100,000 NZD that you bought. This is provided whether or not the currencies even move!

An alternative to buy and hold

Depending on the broker that you use, you would earn around $690 on your initial investment of $1600 in one year or a 43% rate of return. This may vary slightly from broker to broker based on the rates they provide.

Hedging in a bear market

Now, you may be thinking about the risk of an investment like this. Like any other investment, there definitely is risk. The New Zealand Dollar could lose value against the US Dollar. If this happens the broker would take some of your margin deposit to cover the losses.

What is Hedging?

But here is where the second concept I previously introduced comes into play, hedging. Hedging is a strategy that reduces or offsets risk in one security by opening a position in another one. If your first investment loses money, the hedge profits by the same amount to cover your losses. You do not need to sell your initial investment in a bear market, just protect it with a hedge.

For the Forex example used above, an investor could sell a New Zealand Dollar Futures contract, hedging their Forex position. The hedge requires an additional margin deposit of around $2000 but it should profit about the same amount as you would be losing in the Forex position should the New Zealand Dollar drop in price.

So how do you profit from holding this hedge? Well, there are no interest charges applied for Futures positions. Even though you are neutral on the direction of the market, you still receive the interest payments from the Forex position! Of course your returns would be smaller because you used more money as margin to open both positions, but in our example you would still receive an approximate annual return of 19% with no directional risk! ($693 from interest in one year divided by $3600, the margin required for the Forex and Futures position).

Managing your stock market risk with forex trading

Risk Management With Hedging

It seems too simple and too good to be true. You are correct, it isn't that simple. You need to understand how to invest properly in both Forex and Futures, or even use Options on futures to get a better return, as well as decide which instrument to use. The hedge must be managed, although not on a daily basis, because we are investing.

Get the proper education before trying any investment strategy or asset class for the first time. Online Trading Academy offers courses that teach investors how professionals utilize these assets to their advantage. Enroll today at your nearest center to learn more about how you can improve your investment returns!

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