Hedging is a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset.
The reduction in risk provided by hedging also typically results in a reduction in potential profits.
Hedging strategies typically involve derivatives, such as options and futures contracts.
Hedging against investment risk means strategically using financial instruments or market strategies to offset the risk of any adverse price movements. Put another way, investors hedge one investment by making a trade in another.
Technically, to hedge requires you to make offsetting trades in securities with negative correlations. Of course, you still have to pay for this type of insurance in one form or another.
For instance, if you are long shares of XYZ corporation, you can buy a put option to protect your investment from large downside moves. However, to purchase an option you have to pay its premium.
A reduction in risk, therefore, always means a reduction in potential profits. If the investment you are hedging against makes money, you have also usually reduced your potential profit. However, if the investment loses money, and your hedge was successful, you will have reduced your loss.
Hedging techniques generally involve the use of financial instruments known as derivatives. The two most common derivatives are options and futures.
Because there are so many different types of options and futures contracts, an investor can hedge against nearly anything, including stocks, commodities, interest rates, or currencies.
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