What is a Hedge?

You hedge for the same reason you purchase an insurance policy…

When you own a car, you usually purchase an insurance policy to cover losses from potential accidents. If you lose value because the car is totaled, you expect to gain value from the insurance company writing you a check to cover the damage. Similarly, a hedge can counteract losses in the value of an asset.

Generally speaking, it depends. Derivatives, like options and futures contracts, are often used in hedging strategies. These are contracts whose value relies on the underlying security. To create a hedge, you might utilize strategies that seek to gain in value when your main underlying positions lose value.

For example, someone who owns shares of one stock might hedge by buying puts or selling calls in that underlying stock. Someone who owns many stocks (like a portfolio manager) might sell a futures contract that tracks a stock market index like the S&P 500. If the basket of stocks in his portfolio fell, the value of the short futures contract would increase in value, potentially offsetting some of the losses in the stock portfolio.

You can hedge currencies through the exchange rate and foreign exchanges as well, similar to a stock. Just like stock prices fluctuate, currency prices (as they relate to other currencies) fluctuate. The US dollar may be strong against the Japanese yen but weak against the euro at a given time, but that might change later due to economic conditions. Foreign currency hedging can involve using currencies that offset each other’s weaknesses, for example.

A hedging instrument is a general term for any financial instrument used to hedge against the potential loss of value in another asset.

For most long-term, passive investors, hedging is a technique that is seldomly used. It requires a greater knowledge of the markets, access to certain financial products, and requires a delicate balance of timing and execution.

For professional investors, hedging risks and rewards vary greatly depending on the type of hedging actions used. Hedging’s purpose lies in offsetting losses with gains elsewhere. The reward of hedging done well is a reduction in risk of loss if not losses themselves. While hedging may be a bit like insurance, hedging isn’t as secure as insurance. There is no perfect hedge — That unicorn simply doesn’t exist in the real world, only in theory. Most hedging strategies come with a cost. Either the initial investment cost itself, an options contract fee also known as a premium, time in managing the hedges, or higher risk.

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