BECOMING AN EXPERT TRADER(RELOADED)
Episode 1
What Is Hedging? How Does it Work?
Hedging is a risk management strategy employed by individuals and institutions to offset potential losses that may incur on an investment.
Hedging is a strategy that tries to limit risks in financial assets. It uses financial instruments or market strategies to offset the risk of any adverse price movements. Put another way, investors hedge one investment by making a trade in another.
The concept is similar to taking out an insurance policy. If you own a home in a flood-prone area, you would want to protect that asset from the risk of flooding by taking out flood insurance. In financial and crypto markets, hedging works in a similar way. It involves making an investment designed to reduce the risk of adverse price movements in an asset.
How Does Hedging Work?
There are many different hedging methods, but it typically involves the following steps:
Step 1: Establish a primary position
You have an existing position in a specific asset, such as bitcoin or ether. You either own the crypto or have exposure to its prices.
Step 2: Identify the risks
The next step is to identify the risks associated with the primary position. For instance, the risk of owning bitcoin could be that the price might fall.
Step 3: Take a counterposition
You can hedge the risk by taking a position in a related instrument that is expected to move in the opposite direction of the risk identified.
The goal of hedging isn't to make money but to protect from losses. The gain on the hedging position should offset the losses from the main position. It's important to note that perfect hedges are rare. Also, hedging often involves costs, so one needs to consider the cost-effectiveness of the hedge.
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