What is Hedging?
Hedging refers to buying an investment designed to reduce the risk of losses from another investment. It deals with reducing or eliminating the risk of uncertainty. The aim of this strategy is to restrict the losses that may arise due to unknown fluctuations in the investment prices and to lock the profits therein. It works on the principle of offsetting i.e. taking an opposite and equal position in two different markets
A number of specific vehicles exist to help with hedging. These typically include forward contracts, swaps, insurance policies, options, derivatives, and products sold over the counter. Futures contracts prove to be the most popular version of hedging instruments.
Example- If you want to invest in one company to protect yourself from industry weakness, you can buy that company’s stock while simultaneously shorting one of its weaker competitors. The point is that there are lots of potential ways you can hedge your investments, as long as one asset can be reasonably expected to go up in value when the other goes down.
In practice, hedging doesn’t usually eliminate risk altogether (known as a “perfect hedge”). Rather, it is used to lessen the impact of an otherwise devastating event. Think of hedging like buying car insurance — sure, you’ll still have to pay a deductible if you need to use it and you may be without your car for a little while, but it’s a better outcome than not having it at all. The insurance premiums are the cost of reducing the risk, and if you don’t use your insurance, that money is gone.
There are different hedging strategies one can use, depending on the type of investments you work with. When trading derivatives, you can pay a small fee for the right to sell the stock at the same price you bought it, known as a “put option.” Most investors use diversification, or owning different kinds of investments so they don’t all lose value at the same time, as a hedging strategy. Investing in gold is often used as a hedge against inflation, because it keeps its value when the dollar falls.