Double Hedging

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. 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. Double hedging is a trading strategy in which an investor hedges a cash market position using both a futures position and an options 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. 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.

A double hedge occurs when a trader employs both futures and options in order to hedge an existing position.

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.

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 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 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.

Related terms:

Call Option

A call option is a contract that gives the option buyer the right to buy an underlying asset at a specified price within a specific time period. read more

Commodity Futures Trading Commission (CFTC)

The CFTC is an independent U.S. federal agency established by the Commodity Futures Trading Commission Act of 1974. read more

Commodity Futures Contract

A commodity futures contract is an agreement to buy or sell a commodity at a set price and time in the future. Read how to invest in commodity futures. read more

Derivative

A derivative is a securitized contract whose value is dependent upon one or more underlying assets. Its price is determined by fluctuations in that asset. read more

e-CBOT

E-CBOT was an electronic trading platform allowing traders to transact in futures and options contracts listed on the Chicago Board of Trade (CBOT). read more

Futures

Futures are financial contracts obligating the buyer to purchase an asset or the seller to sell an asset at a predetermined future date and price. read more

Futures Contract

A futures contract is a standardized agreement to buy or sell the underlying commodity or other asset at a specific price at a future date. read more

Hedge

A hedge is a type of investment that is intended to reduce the risk of adverse price movements in an asset. read more

Options

Options are financial derivatives that give the buyer the right to buy or sell the underlying asset at a stated price within a specified period. read more

Options Contract

An options contract gives the holder the right to buy or sell an underlying security at a predetermined price, known as the strike price. read more