What Is Double Hedging?
Double hedging is a trading strategy in which an investor hedges a cash market position using both a futures position and an options position. This is used when it is not effective or is impossible due to regulatory restraints to use just one derivatives market to complete a hedge.
Key Takeaways
- A double hedge occurs when a trader employs both futures and options in order to hedge an existing position.
- For instance, a long investor may sell futures and also purchase put options to neutralize any downside moves in the market.
- A double hedge would be sought if one of the futures or options markets had insufficient capacity to handle the total size of a required hedge, either due to regulatory limits or illiquidity.
Understanding Double Hedging
Double hedging utilizes both a futures contract and an options contract to increase the size of a hedge in a market position. Like any hedging strategy, a double hedge is intended to protect investors from losses due to price fluctuations. Using a double hedging strategy, investors are able to reduce their risk by purchasing put options as well as short positions in the futures market of the same amount as the underlying long position.
The hedge is doubled when there is insufficient liquidity in either one of the options or futures markets on its own, or if executing a full hedge in just one market would trigger a position limit.
As defined by the Commodity Futures Trading Commission (CFTC), a double hedge would be required when a trader holds a position in which a futures market hedge would exceed 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 a larger overall return.
Other Hedging Investment Strategies
Investors tend to think of hedges as insurance policies against loss. For instance, an investor who would like to invest in and enjoy 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 derivatives markets to work, particularly options and futures. Futures contracts are commitments to trade an asset at a 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 thebuyer to actually purchase or sell 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.
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