what is Hedging

what is Hedging

hedgeHedging an investment is a way of attempting to ensure against a negative event happening. Individuals hedge whenever they purchase insurance. If you purchase car insurance, it does not mean they will never be in an accident. It simply means that it reduces the negative impact of an accident, financially speaking at least.

For example, you own a fund named ABC Fund in your portfolio. You want and expect this particular fund to go up. But in order to hedge against the potential of ABC Fund going down, you invest in a new fund called XYZ fund which is negatively correlated with ABC Fund. So when ABC increases in value, XYZ will decrease in value. If you own a stock and you believe the company you invested in has good long term potential but you are concerned about short term potential losses you can buy a put option. A put option allows you as the buyer to sell the stock at a set price in the future.

Hedges are also used in futures trading and futures contracts. Suppose you own a bakery and you are concerned about the rising price of wheat which affects the company. You can protect or hedge against this uncertainty by entering into a futures contract which allows you to buy the wheat on a specific price at a future set date. If wheat prices jump, the hedge of the futures contract will pay off because you can buy the wheat at a lower price than the market. What happens if the price goes down illustrates one of the drawbacks to hedging. If the price of wheat drops, you are obligated to pay the price in the contract and it would have been less risky if you did not hedge at all.

Hedging has shown growth and has to spread to all areas of finance and business. This is quite common with multinational companies, where they outsource resources and factories to countries which have cheaper labour costs to hedge against currency loss and risk. Every investment is some form of a hedge. Not only does it protect the investor but hedging runs the market much more efficiently.

Hedging is not to be confused with hedge funds and this is a common misconception. Hedging’s main purpose, be it in your financial portfolio or your business, is to reduce or transfer the risk. Just like any other risk and reward trade, hedging can result in lower returns that you receive if you gamble on a volatile investment but it also prevents from drastic financial losses. Hedge funds on the other hand, confront risk straight on and generally promises very large returns. Hedge funds are marketing strategies used heavily by investment bankers and top shot corporate bankers and are much more technical compared to basic or intermediate level investing.

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