What is a Hedge?

Robinhood Learn
Democratize Finance For All. Our writers’ work has appeared in The Wall Street Journal, Forbes, the Chicago Tribune, Quartz, the San Francisco Chronicle, and more.
Definition:

In the investment world, hedging is the practice of offsetting potential losses from one asset with potential gains in another.

🤔 Understanding a hedge

A hedge is an investment, which attempts to offset potential losses from one asset with potential gains in another asset. The idea is to try and ensure that if one investment fails, there is another investment — assumed not to move in tandem with the first investment — to help offset the loss. There are many hedging strategies, and they all revolve around reducing risk. While there are more sophisticated methods of hedging available to some investors, there is no perfect hedge that eliminates risk entirely.

Example

Say you invest a chunk of money in the fictional company Frankie’s Foghorns. You expect the company’s stock price to rise. However, since you’ve invested a lot, you want some backup in case the price goes down instead. To help mitigate the risk of your investment in Frankie’s Foghorns, you buy a put option, giving you the right to sell your stock at the strike price. The put option is your hedge limiting the downside risk of a falling stock price.

Takeaway

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.

Ready to start investing?
Sign up for Robinhood and get stock on us.Certain limitations apply

New customers need to sign up, get approved, and link their bank account. The cash value of the stock rewards may not be withdrawn for 30 days after the reward is claimed. Stock rewards not claimed within 60 days may expire. See full terms and conditions at rbnhd.co/freestock. Securities trading is offered through Robinhood Financial LLC.

Tell me more…

What kind of investments can be used to hedge?

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.

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 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.

Additional Disclosure:

Options trading entails significant risk and is not appropriate for all customers. Individuals must read and understand the Characteristics and Risks of Standardized Options before engaging in any options trading strategies. Options transactions are often complex and may involve the potential of losing the entire investment in a relatively short period of time. Robinhood Financial does not guarantee favorable investment outcomes. The information presented is not a recommendation of a security or investment strategy. Supporting documentation for any claims, if applicable, will be furnished upon request.

Ready to start investing?
Sign up for Robinhood and get stock on us.Certain limitations apply

New customers need to sign up, get approved, and link their bank account. The cash value of the stock rewards may not be withdrawn for 30 days after the reward is claimed. Stock rewards not claimed within 60 days may expire. See full terms and conditions at rbnhd.co/freestock. Securities trading is offered through Robinhood Financial LLC.

2599802

Related Articles

You May Also Like

PARTICIPATION IS POWER™

This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Options trading entails significant risk and is not appropriate for all customers. Customers must read and understand the Characteristics and Risks of Standardized Options before engaging in any options trading strategies. Options transactions are often complex and may involve the potential of losing the entire investment in a relatively short period of time. Certain complex options strategies carry additional risk, including the potential for losses that may exceed the original investment amount.

Commission-free trading of stocks, ETFs and options refers to $0 commissions for Robinhood Financial self-directed individual cash or margin brokerage accounts that trade U.S. listed securities and certain OTC securities electronically. Keep in mind, other fees such as trading (non-commission) fees, Gold subscription fees, wire transfer fees, and paper statement fees may apply to your brokerage account. Check out Robinhood Financial’s Fee Schedule for details.

Brokerage services are offered through Robinhood Financial LLC, (RHF) a registered broker dealer (member SIPC) and clearing services through Robinhood Securities, LLC, (RHS) a registered broker dealer (member SIPC). Cryptocurrency services are offered through Robinhood Crypto, LLC (RHC) (NMLS ID: 1702840). Robinhood Crypto is licensed to engage in virtual currency business activity by the New York State Department of Financial Services. The Robinhood spending account is offered through Robinhood Money, LLC (RHY) (NMLS ID: 1990968), a licensed money transmitter. A list of our licenses has more information. The Robinhood Cash Card is a prepaid card issued by Sutton Bank, Member FDIC, pursuant to a license from Mastercard®. Mastercard and the circles design are registered trademarks of Mastercard International Incorporated. RHF, RHY, RHC and RHS are affiliated entities and wholly owned subsidiaries of Robinhood Markets, Inc. RHF, RHY, RHC and RHS are not banks. Products offered by RHF are not FDIC insured and involve risk, including possible loss of principal. RHC is not a member of FINRA and accounts are not FDIC insured or protected by SIPC. RHY is not a member of FINRA, and products are not subject to SIPC protection, but funds held in the Robinhood spending account and Robinhood Cash Card account may be eligible for FDIC pass-through insurance (review the Robinhood Cash Card Agreement and the Robinhood Spending Account Agreement).

2784249

© 2024 Robinhood. All rights reserved.
Follow us on

This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Options trading entails significant risk and is not appropriate for all customers. Customers must read and understand the Characteristics and Risks of Standardized Options before engaging in any options trading strategies. Options transactions are often complex and may involve the potential of losing the entire investment in a relatively short period of time. Certain complex options strategies carry additional risk, including the potential for losses that may exceed the original investment amount.

Commission-free trading of stocks, ETFs and options refers to $0 commissions for Robinhood Financial self-directed individual cash or margin brokerage accounts that trade U.S. listed securities and certain OTC securities electronically. Keep in mind, other fees such as trading (non-commission) fees, Gold subscription fees, wire transfer fees, and paper statement fees may apply to your brokerage account. Check out Robinhood Financial’s Fee Schedule for details.

Brokerage services are offered through Robinhood Financial LLC, (RHF) a registered broker dealer (member SIPC) and clearing services through Robinhood Securities, LLC, (RHS) a registered broker dealer (member SIPC). Cryptocurrency services are offered through Robinhood Crypto, LLC (RHC) (NMLS ID: 1702840). Robinhood Crypto is licensed to engage in virtual currency business activity by the New York State Department of Financial Services. The Robinhood spending account is offered through Robinhood Money, LLC (RHY) (NMLS ID: 1990968), a licensed money transmitter. A list of our licenses has more information. The Robinhood Cash Card is a prepaid card issued by Sutton Bank, Member FDIC, pursuant to a license from Mastercard®. Mastercard and the circles design are registered trademarks of Mastercard International Incorporated. RHF, RHY, RHC and RHS are affiliated entities and wholly owned subsidiaries of Robinhood Markets, Inc. RHF, RHY, RHC and RHS are not banks. Products offered by RHF are not FDIC insured and involve risk, including possible loss of principal. RHC is not a member of FINRA and accounts are not FDIC insured or protected by SIPC. RHY is not a member of FINRA, and products are not subject to SIPC protection, but funds held in the Robinhood spending account and Robinhood Cash Card account may be eligible for FDIC pass-through insurance (review the Robinhood Cash Card Agreement and the Robinhood Spending Account Agreement).

2784249

© 2024 Robinhood. All rights reserved.