In investing, a hedge is a strategy used to reduce or offset the risk of adverse price movements in an asset. This is typically done by taking a position in a related security or asset that is expected to move in the opposite direction of the asset being hedged.
For example, if an investor owns a stock that they believe may decline in value, they could hedge their position by purchasing a put option on that stock. If the stock does indeed decrease in value, the put option will increase in value, offsetting some of the losses from the decline in the stock price.
Hedging is often used by investors to protect against potential losses, but it can also limit potential gains. There are many different types of hedging strategies, including using derivatives such as options and futures contracts, as well as diversifying investments across different asset classes.
Some examples of how hedging works in investing:
- An investor who owns a large portfolio of stocks may want to hedge their position by buying put options on a stock market index like the S&P 500. If the market declines, the value of the put options will increase, offsetting some of the losses from the stocks in the portfolio.
- A company that relies on a particular commodity for its business (such as oil) may use futures contracts to hedge against price fluctuations. By locking in a price for future delivery of the commodity, the company can protect itself against a sudden increase in the price of the commodity.
- An investor who owns a stock that has had a significant run-up in price may use a collar strategy to hedge their position. This involves buying a put option on the stock (to protect against a decline in price) and selling a call option on the stock (to generate income and limit potential gains).