What is hedging?
Hedging is a strategy that helps an investor reduce the risks he or she takes on an investment. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract and put option which are the two most common forms.
Think of hedging similar as to your house insurance, which is purchased as a protection against loss of your home. Although it doesn’t protect you against all losses. It prevents you from completely losing your investment.
Hedging works the same way but in reality it is much more complicated than just buying an insurance.
We will use an example to show you how it works:
John wants to invest in XYZ Inc. But he is unsure of how the business is going to perform in the short term although he believes in the company in the long run. He purchases a put option (which is a derivative) on the company. This gives him the rights but not the obligation to sell his stocks at a predetermined specific price (strike price) therefore avoiding market fluctuations. This is not considered a loss as his stocks will be garanteed to sell at this predetermined put option price.
Let’say for example that he bought the stock for $40. Bought a put option at $30.The stock price falls to $20. He will be able to sell his stock at $30. His loss will be reduced by the gain in the put option. This strategy is called a married put.
A perfect hedge reduces your risk to nothing (except for the cost of the hedge) meaning that it will eliminate all the market risk from a portfolio. It will require a 100% correlation which makes it very rare.
Hedging is used as a way to protect an investment from losses and by no means to make money.
Before deciding to use hedging, you must asks yourself if the benefits are worth the costs. Remember that a hedge is not free and you will have to pay a price.