Tips & Tricks

Hedging 101: How to Protect Your Investments Without Losing Your Edge

Back
Paxful Team
Paxful Team

The essence of investment management is the management of risks, not the management of returns.” – Benjamin Graham.

Benjamin Graham, regarded by many as the father of value investing, emphasized that smart investing is about managing risks rather than chasing profits. This principle is at the heart of hedging—a strategy to minimize losses against specific risks. Think of it as a safety net for your money, providing protection when markets get unpredictable.

But how can you do this?

We’ll look at easy ways to manage your risk. In this article, we’ll look at easy ways to manage your risk and learn about old-school tactics and new tricks to guard your wealth. 


Key takeaways:

  • Hedging is like a safety net for your investments. It helps protect you from specific risks like market ups and downs, inflation, or currency changes. While it can reduce losses, it doesn’t remove all risks and might limit your profit.
  • Different tools can help you hedge effectively. Forward contracts, futures, options, swaps, or diversifying your investments can work. For example, you can protect against inflation with real estate or TIPS or deal with crypto swings using stablecoins and stop-loss orders.
  • Hedging comes with trade-offs. It costs money (like paying for insurance), limits your potential profits, and can be complicated to manage.

What is Hedging?

Hedging is a financial strategy designed to protect investments by reducing risks. It involves making offsetting investments that balance potential losses from adverse market movements. Simply put, hedging is like car insurance: you hope you won’t need it, but it protects your assets if something goes wrong.

While it comes with some costs, hedging can safeguard you from significant losses during volatile times. Whether it’s currency fluctuations, commodity price swings, or market downturns, investors, businesses, and individuals use hedging to reduce risk and gain peace of mind.

What’s the difference between hedging and diversification?

Diversification and hedging are strategies aimed at minimizing risk, but they differ. Here is the difference:

  • Diversification spreads investments across various assets or markets to reduce overall risk—usually, highly uncorrelated assets. For example, if you invest in both stocks and real estate, a decline in one may be balanced by stability or growth in the other. 
  • Hedging, on the other hand, focuses on protecting against specific risks. For example, if you own Bitcoin (BTC) and are worried its price might fall, you can use a futures contract to lock in a fixed selling price. This way, even if the market drops, you reduce potential losses.

💡Fun fact:  Bitcoin futures allow traders to bet on Bitcoin’s price or protect themselves from price changes without owning it. 

Hedging versus diversification.

Related: 👉How to diversify your crypto portfolio.

Why hedge? (Understanding its purpose)

The main goal of hedging is to lower risk, not to make money. This way,  investors feel more secure about their investments. Hedging can protect against various risks:

  • Market fluctuations
  • Currency exchange rate changes 
  • Interest rate shifts 
  • Commodity price swings

Hedging lets investors take on more risk in other areas. They can make bolder moves knowing they have protection. It’s beneficial for businesses that deal with foreign currencies or commodities.

What are some key hedging strategies?

Hedging helps protect investments from various risks. These strategies can guard against inflation, crypto volatility, currency controls, and economic uncertainty.

1. Hedging against inflation

Inflation, the gradual loss of purchasing power, erodes wealth over time. It’s vital to take action to safeguard your financial and business well-being. Here are some practical ways you can consider:

  • Invest in real estate: Property values often climb alongside inflation, making real estate a solid long-term investment.
  • Buy treasury inflation-protected securities (TIPS): These bonds adjust with inflation rates.
  • Buy gold and precious metals: Known for holding their value, they’re classic choices during inflationary periods.
  • Purchase stocks of companies with pricing power: They can raise prices to match inflation.
  • Buy commodities: As prices rise, commodities like oil or agricultural products often follow suit.
Countries inflation statististics.

Global Inflation map. Source: IMF

Related:👉What are the effects of inflation on Bitcoin?

2. Hedging against crypto volatility

Cryptocurrency markets can be highly unpredictable, but there are strategies to help manage this risk:

  1. Use stop-loss orders: Set a price limit to automatically sell if the market takes a sharp downturn, helping minimize losses.
  2. Diversify crypto holdings: Spread your investments across different cryptocurrencies to avoid relying too much on one.
  3. Consider stablecoins like USDT & USDC: These are tied to traditional assets like the US dollar, offering more stability during periods of market volatility.

Related:👉Build the Best Crypto Portfolio: Why Diversification Is Important

3. Hedging against currency controls

Currency controls can limit your access to foreign exchange.  So, here are a few ways to get ahead:

  • Hold multiple currencies: Spread your risk by holding different national currencies.
  • Invest in multinational companies: They often have global revenue streams, providing exposure to different currencies.
  • Use cryptocurrency: It can bypass traditional banking systems and offer greater flexibility.
  • Open foreign bank accounts: This can provide access to different currencies.
  • Invest in foreign markets: Diversifying in international markets can provide exposure to different economic systems.

💡Fun fact:  Paxful’s peer-to-peer platform can facilitate cross-border transactions, offering an alternative to traditional currency exchanges.

4. Hedging against economic uncertainty

Economic instability can threaten investments. Here’s how to protect against it:

  • Build an emergency fund: Cash reserves provide a safety net.
  • Invest in defensive stocks: Utilities and consumer staples often perform well in downturns.
  • Consider bonds: Government bonds can offer stability during market turmoil.
  • Explore alternative investments: Real estate or commodities can balance a portfolio.
  • Use dollar-cost averaging: Regular, fixed investments can smooth out market fluctuations.

Related: 👉 What is Dollar Cost Averaging (DCA) in Crypto?

What are some types of hedging?

There are several types of hedging, each suited to different situations and markets. Below are the main types of hedging, along with simple examples of how each one works:

  • Forward contracts: An agreement to buy or sell something at a set price in the future. For example,  a company agrees to purchase oil at today’s price, even though delivery is in six months, to avoid paying a higher price later.
  • Futures contracts: Similar to forward contracts, these are traded on exchanges and have set terms. For instance, a  farmer locks in today’s price to sell their wheat six months from now, no matter how the price changes.
  • Options: These give you the right, but not the obligation, to buy or sell an asset at a set price. For example, a company might purchase an option to sell its stock at a specific price if its value drops, protecting against losses.
  • Swaps: This involves exchanging cash flows or financial products with another party. For example, a company might swap a fixed-interest loan for a floating-rate one, hoping to benefit from lower interest rates over time.
  • Currency hedging protects against changes in the value of different currencies. For example, a U.S. business locks in a fixed exchange rate to prevent itself from losing money if the Euro weakens compared to the Dollar.
  • Equity hedging: This protects against stock market losses, often through options. An investor might buy an option to sell their stocks at a specific price, providing insurance against market downturns.
  • Commodity hedging protects against price swings in commodities like oil, gold, or crops. An airline, for example, could secure a fixed price for fuel over the next year, avoiding higher costs if fuel prices increase.

What are some of the drawbacks of hedging?

Hedging is not a perfect science and comes with some drawbacks that include: 

  • Cost: Hedging costs money. For example, if you buy an insurance policy for your investment (like an option), you must pay a premium. If the market doesn’t go against you, you lose that money spent on the hedge.
  • Limited profit: While hedging can protect you from losses, it limits your chance to make a big profit. For example, if you buy a hedge against a stock price rise and the stock goes up a lot, your hedge might prevent you from fully benefiting.
  • Complexity: Hedging can be complicated. For instance, managing different financial products (like futures or options) requires knowledge and time to track. 
  • Over-hedging: Sometimes, people protect themselves too much. If you hedge too often or too much, you might spend a lot on unnecessary protection. For example, if you buy multiple types of insurance for the same risk, you might spend more than you need to.
  • False sense of security: Hedging doesn’t eliminate risk. You might think you’re fully protected, but your hedge might not work as planned if the market moves unexpectedly. For example, if you hedge against a currency risk but the market moves in a way you didn’t expect, your hedge could still expose you.
  • Missed opportunities: Hedging can stop you from making money if the market moves in your favor. For example, if you hedge against a stock price going up, but the stock rises significantly, your hedge might limit the profits you could have made if you didn’t hedge at all.

Here is how to implement a personal hedging plan

1. Identify your risks:

Some of the risks include:

  • Job loss: Unexpected unemployment can significantly impact your financial stability. Without an emergency fund or a backup income source, you could be left scrambling to cover your bills while you look for new work. And if finding a new job takes longer than expected, it will stretch your savings thin, causing unnecessary stress.
  • Market downturns: Economic fluctuations can negatively affect your investments and savings. When markets dip—like during the 2008 financial crisis—it can hit your investments hard. 
  • Inflation: Rising prices can erode your purchasing power and reduce the value of your savings. Imagine if your income only grows by 2%, but inflation jumps 4%—your money is effectively worth less, and you’ll find yourself adjusting your budget to make ends meet.
  • Currency fluctuations:  If you’re traveling, doing business internationally, or even investing in foreign markets, currency exchange rates can mess with your finances. A sudden drop in the value of your currency (like the dollar) can make everything more expensive.

2. Choose Hedging tools:

  • Diversify your investments: Spread your money across different assets—stocks, bonds, real estate—to reduce risk. If one area drops, the others can help balance things out.
  • Build a cash reserve: Set aside 3-6 months of expenses in an emergency fund. This keeps you covered if you lose your job or face a financial setback.
  • Protect yourself with insurance: Health, property, and life insurance can protect you from unexpected costs and give you peace of mind in emergencies.
  • Invest in Inflation-Protected Securities(TIPS): Treasury TIPS adjusts with inflation, helping your money hold its value when prices rise.
  • Match tools to your risks: Tailor your hedging tools to the specific risks you face. For example, foreign currency or international stocks can protect against currency risk if you invest or travel abroad.

Bottom line: Is hedging right for you?

. To answer if it is right for you, do the following:

  • Assess your needs: Take a close look at your financial goals, risk tolerance, and what risks you want to protect against (like inflation or currency fluctuations).
  • Start simple: If you’re new to hedging, first understand what works for you, and then begin with basic strategies like diversifying your portfolio or using stop-loss orders. These can help you manage risk without complicated tools.
  • Consider the cost: Hedging isn’t free. Strategies like options come with premiums that can eat into your profits.

Important Note: Paxful does not provide investment, tax, or legal advice, and you are solely responsible for determining whether any financial transaction strategy or related transaction is appropriate for you based on your personal investment objectives, financial circumstances, and risk tolerance. Paxful may provide information that includes but is not limited to blog posts, articles, podcasts, tutorials, and videos. The information contained therein does not constitute investment advice, financial advice, trading advice, or any other advice, and you should not treat any of the content as such. Paxful does not recommend that any digital asset should be bought, earned, sold, lent out, or held by you, and will not be held responsible for the decisions you make to buy, sell, trade, lend, or hold digital assets based on the information provided by us.


Share this post

Paxful Team

Paxful Team

Paxful is a marketplace where people can buy and sell cryptocurrencies directly with each other. You can get digital money instantly and pay with debit, credit, cash, and any currency.

You might also be interested in

How to Convert Gift Cards Into Crypto and Vice Versa

The Basics

How to Convert Gift Cards Into Crypto and Vice Versa

Instead of letting gift cards expire or collect dust in a drawer, why not turn them into crypto? Let us show you the process and how you can swap it back.

Paxful Team
Paxful Team
6 mins read
Is your Paxful Account Restricted? Here are 4 Reasons Why

The Basics

Is your Paxful Account Restricted? Here are 4 Reasons Why

A Paxful account can be restricted for either security reasons or for violating our ToS. The good news is that not all restrictions are permanent.

Paxful Team
Paxful Team
7 mins read

Start trading on Paxful today

Trade Bitcoin, Ethereum, Tether and more with over 14 million global users

Sign up now