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.
 Advantages and Disadvantages of Various Hedges
Forward Contracts:

Advantages

- Can be written for any amount and term

- Offers a complete hedge
Disadvantages

- Difficult to find a counterparty (no liquidity)

- Requires tying up capital
- Subject to default risk
Futures Contracts:

Advantages

- Lots of liquidity
- Position can be reversed easily
- Doesn’t tie up much capital
Disadvantages

- Written for fixed amounts and terms

- Offers only a partial hedge
- Subject to basis risk (bond issuer can default)
Options:

Advantages

- Limits potential losses without limiting potential gains

- Doesn’t tie up much capital
- Position can be reversed
Disadvantages

- Written for fixed amounts and terms

- Not much liquidity
- Subject to basis risk
- Offers only a partial hedge
Swaps:

Advantages

- Reduces transactions costs

- Maintains informational advantages
- Very long time period hedge possible
Disadvantages

- Not much liquidity

- Subject to default risk
Drawbacks of Hedging
“Hedging is not always successful in providing safeguard against undesirable change in
prices. There are some limits of hedging. The practice of hedging will provide full
protection only if prices in cash or future markets move together in perfect accord with
each other.”

Hedging is not always successful in providing safeguard against undesirable change in

prices. There are some limits of hedging. The practice of hedging will provide full
protection only if prices in cash or future markets move together in perfect accord with
each other. Cash and future prices do not always move together. If it so happens that the
prices in the two markets go in mutually opposite direction, hedging cannot be of much
help. 

All the more, it also can happen that the price changes in the commodity markets that are
not of the same grade are not parallel. The prices of grades contracted market may rise
but the prices of other grades of commodities may fall. This will create difficulties in
hedging. The transactions in commodities exchange are allowed only for a given
quantity. Usually exchange in a particular quantity of a particular commodity is allowed.
For example, only 100 bales of jute may be allowed for .This quantity is called a trading
unit.

Usually, it happens that a merchant trades in a commodity that is not the trading unit. At
such a juncture hedging does not come in handy. There may be a rise of prices in
products not because of the increase in price of raw material but because of increase in
other expenses like wages and over heads. The producer will not benefit from hedging
under these conditions, rather he may get confused and perturbed. 

It is the raw materials that can be best protected from price rise effectively. So, hedging is
helpful only in case of raw material and not for other expenses. Hedging also involves
other expenses that a person has to bear. He has to pay commission to brokers and also
has to spend a lot of time and efforts for estimating future trends in prices. As a result of
these kinds of expenses the cost price of goods can increase by a considerable amount.
So, hedging is not a totally independent activity and should be resorted to with much
care.