Traders go through a series of evolutionary landmarks. These landmarks range from getting stuck in the land of magic indicators and system optimisation to the quest for the perfect exit. Along the way, they often take a detour into the domain of hedging. Part of the attraction of hedging is a misunderstanding of what its purpose is, its true purpose is to lock in a current price point against future fluctuations. If you are a primary producer you can see why this is an attractive tool. You can lock in a forward price for your commodity – this acts to smooth out fluctuations in your cash flow and generally makes your life much easier. Gold miners hedge all the time.
The problem with traders who become obsessed with hedging is the belief that you can hedge a position but still take advantage of future positive price movements – if only it were that easy. Such traders fail to grasp the point about locking in a current price. Hedging will always extract a cost – this cost can come at the risk of missing out on a move. This is the case with hedged gold miners during the recent lift in the price of gold and this can be combined with the actual cost of establishing and managing the hedge.
As always there are examples of the impact of hedging on trades – I have already mentioned the performance of gold miners but currency hedging can also have an impact upon returns. Below is a chart of IVV versus IHVV. Both track the S&P500 locally but IHVV is currency hedged. You can see the impact hedging has on returns.
There are no free lunches in markets.
