What is Double Hedging
BREAKING DOWN Double Hedging
Double Hedging is a hedging strategy that relies on both a futures contract and an options contract to increase size of the hedge in a cash market position. The double hedge strategy is intended to protect investors from losses due to price fluctuations. Using a double hedging strategy, investors are able to reduce their risk by taking put options or short positions of the same amount. The hedge is doubled in size, while the size of exposure is the same.
As defined by the Commodity Futures Trading Commission (CFTC), a double hedge implies that a trader holds a long position in a futures market which exceeds the speculative position limit and offsets a fixed price sale although the trader has ample supply of the asset to meet sales commitments. According to the CFTC, a speculative position limit is the maximum position in a given commodity future or option that an individual entity may hold, unless that entity is eligible for a hedge exemption.
For instance, an investor with a stock portfolio of $1 million who wishes to reduce risk in the broad market can begin by purchasing put options of a similar amount on the S&P 500. By subsequently initiating an additional short position in the S&P 500 using index futures contracts, the investor double hedges, reducing risk and increasing the likelihood of larger overall return.
Double Hedging and other Hedging Investment Strategies
Investors tend to think of hedges as insurance policies against loss. For instance, an investor who would like to invest and enjoy in the benefits of a successful emerging technology, but who needs to limit the risk of loss in case the technology doesn’t deliver on its promise, may look to a hedging strategy to restrict the potential downside.
Hedging strategies rely on the use of derivative markets to work, particularly options and futures. Futures contracts are commitments to trade an asset at set price at a specified time in the future.
Options contracts, on the other hand, occur when the buyer and seller agree to a strike price for an asset on or before a set expiration date, but there is no obligation for the buyer to actually purchase the asset. There are two types of options contracts, put and call.
Put option contracts provide the owner of an asset the right, but not the obligation, to sell a specific quantity of an asset at a set price by a set date. Conversely, a call option provides the speculative buyer of an asset the right, but not the obligation, to purchase a specific quantity of an asset at a set price by a set date.