What is a Hedge?

Definition:

A hedge in investing is the practice of offsetting potential losses in one asset with potential gains in another investment — importantly, a hedge should generally be expected to see its price move not in tandem with the asset being hedged.

🤔 Understanding a hedge

A hedge is an investment to offset the potential for loss in another investment. The idea is to ensure that if one investment fails, there is another investment — assumed not to move in tandem with the first investment — to offset the loss. There are many hedging strategies, and they all revolve around finding a risk management strategy to try to keep your portfolio from being gutted by a downturn in one type of investment. The idea of a hedge is to attempt to ensure that if one investment fails, there is another investment on the rise to offset the loss of the first. There is no perfect hedge without any risk of loss. Hedge funds leverage combined investments and use sophisticated hedging methods, but you do not have to invest in a hedge fund to use hedging strategies in your portfolio.

Example

Say you invest a chunk of money in the fictional tech company Flibbertigibbets Dot Com. You expect the company’s stock price to rise. However, since you’ve invested a lot, you want some insurance should the price go down instead. To mitigate that risk, you buy a put option to sell your Flibbertigibbets Dot Com stock at its current price. The put option is your hedge against the risk of a falling stock price.

Takeaway

A hedge is like 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.

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What kind of investments can be used with hedging?

Items that can be bought and sold without physically taking ownership of the product (like stocks, bonds, options, and futures contracts) are probably the most common instruments of hedging and more easily allow other hedging strategies as well.

Derivatives are often used in hedging strategies. These are contracts whose value relies on the underlying security. A call option order lets you buy stocks at a specific price. You don’t have to buy the stock, but it gives you the option of buying it at a specified price. Options let you hedge by creating a situation where you can offset losses in securities you hold, but you don’t have to act unless the conditions you want occur. There are options available to hedge against an unfavorable rise or fall in the security you hold. Put options (which give you the ability to sell a security at a specific price) and call options (ability to buy at a certain price) are two common options. Futures are similar to options, but for commodities. Commodities are things like sugar, wheat, oranges, and oil.

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 sing currencies that offset each other’s weaknesses, for example.

What is a hedging instrument?

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

What are the risks and rewards of hedging?

For most investors, hedging will not be a factor in their investing. Non-professional investors are cautioned to never have an investment so great in one asset that they require a hedge.

For professional investors, hedging risks and rewards vary greatly depending on the type of hedging actions used. Hedging’s purpose lies in offsetting loss with gains elsewhere. The reward of hedging done well is a reduction in losses. 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, time in managing the hedges, or higher risk.

What are hedge funds?

A hedge fund is a lot like a mutual fund (an investment that works with the pooled money of many investors) but on steroids. It is enhanced as it uses complex, and often more risky, investments and investment strategies on a large scale. While hedging usually involves trying to reduce risk, and hedge funds do use some pretty sophisticated hedging techniques, hedge funds are generally more about maximizing potential returns than reducing risk overall. They fall under fewer regulations than a mutual fund or ETF, but only the big kids get to play in hedge funds. Hedge funds are only allowed to accept funds from accredited investors, those who the SEC deems to have enough income, net worth, and investing experience, to handle the increased risk and complexity of a hedge fund.

Additional Disclosure:

Options transactions may involve a high degree of risk. Please review the options disclosure document entitled the Characteristics and Risks of Standardized Options available through about.robinhood.com/legal or the occ.com to learn more about the risks associated with options trading.

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Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory.

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