Although it may sound like the term “hedging” refers to something done by your gardening-obsessed neighbor, when it comes to investing, hedging is a useful practice that every investor should be a𝓰ware of. In the stock market, hedging is a way to get portfolio protection—and protection is often just as important as portfolio appꩲreciation.

H🌟edging is often discussed more broadly than it is explained. However, it is not an esoteric term. Even if you are a beginning investor, it can be beneficial to learn what hedging is and how it works.

What Is Hedging?

The best way to understand hedging is to think of it as a form of insurance. When people decide to🌄 hedge, they are insuring themselves against a negative event’s impact on their finances. This doesn’t prevent all negative events from happening. However, if a negative event does happen and you’re properly hedged, the event’s impact is reduced.

In practice, h🌠edging occurs almost everywhere. For example, if you buy🐎 homeowners insurance, you are hedging yourself against fires, break-ins, or other unforeseen disasters.

澳洲幸运5开奖号码历史查询:Portfolio managers, individual 澳洲幸运5开奖号码历史查询:investors, and 澳洲幸运5开奖号码历史查询:corporations use hedging techniques to reduce their exposure to various risks. In financial markets, however, hedging is not as simple as paying an🍰 i𒈔nsurance company a fee every year for coverage.

Hedging againstﷺ investment risk means strategically usinꦅg financial instruments or market strategies to offset the risk of any adverse price movements. Put another way, investors hedge one investment by making a trade in another.

Technically, to hedge requires you to make offsetting trades in securities with 🦹negative correlations. Of course, you still have to pay for this type of insurance in one form or another.

For instance, if you have long shares of the XYZ corporation, you can buy a 澳洲幸运5开奖号码历史查询:put option to 澳洲幸运5开奖号码历史查询:protect your investment from large🦩 down🍸side moves. However, to purchase an option, you have to pay its premium.

A reduction in risk, therefore, always means a redu🌊ction in potential profits. Hedging, for the most part, is thus a technique that is meant to reduce a potential loss (and not maximize a potential gain). If the investment you are hedging against makes money, you have also usually reduced your potential profit. However, if the investment loses money, and your hedge was successful, you will have reduced your loss.

Understanding Hedging

Hedging techniques generally involve the use of financial instruments known as 澳洲幸运5开奖号码历史查询:derivatives. Two of the most common derivatives are options and futures. With derivatives, you can develop trading strat🐈egies where a l🌺oss in one investment is offset by a gain in a derivative.

Suppose you own shares of Cory’s Tequila Corporation (ticker: CTC). Although you believe in the company for the long run, you are worried about some short-term losses in the tequila industry. To protect yourself from a fall in CTC, you can buy a put option on the company, which gives you the right to sell CTC at a specific price (also called the 澳洲幸运5开奖号码历史查询:strike price). This strategy is known as a married put. If your stock price tumbles below the strike price, these losses will be offset by gains in the 澳洲幸运5开奖号码历史查询:put option.

Another classic hedging exam✅ple involves a company that depends on a certain commodity. Suppose that Cory’s Tequila Corporation is worried about the volatility in the price of agave (the plant used to make tequila). The company would be in deep trouble if the price of agave were to skyrocket, because this would severely impact their profits.

To protect against the uncertainty of agave prices, CTC can enter into a 澳洲幸运5开奖号码历史查询:futures contract (or its less-regulated cousin, the 澳洲幸运5开奖号码历史查询:forward contract). A futures contract is a type of hedging instrument that allows the company to buy the agave at a specific price 澳洲幸运5开奖号码历史查询:at a set date in the future. Now, CTC can budget without worrying about theღ fluctuating price 𓆏of agave.

If the agave skyrockets above the price specified by the futures contract, this hedging strategy will have paid off because CTC will save money by paying the lower price. However, if the price goes down, 🌸CTC is still obligated to pay the price in the contract. Therefore, they would have been better off not hedging against this risk.

Because there are so many different types of options an🐷d futures contracts, an investor can hedge against nearly anything, including stocks, commodities, interest rates, or currencies.

Disadvantages of Hedging

Every hedging strategy has a cost associated with it. So, before you decide to use 🏅🔥hedging, you should ask yourself if the potential benefits justify the expense. Remember, the goal of hedging isn’t to make money; it’s to protect from losses. The cost of the hedge, whether it is the cost of an option—or lost profits from being on the wrong side of a futures contract—can’t be avoided.

While it’s tempting to compare hedging to insurance, insurance is far more precise. With insurance, you are completely compensated for your loss (usually minus a deductible). Hedging a portfolio isn’t a perfect science. Things can easily go wrong. Although risk managers are always aiming for the 澳洲幸运5开奖号码历史查询:perfect hedge, it is very difficult to achieve in practice.

What Hedging Means for You

The majority of investors will never trade a derivative contract. In fact, most 澳洲幸运5开奖号码历史查询:buy-and-hold investor🐲s ignore short-term fluctuations altogether. For these investors, there is little point i✨n engaging in hedging because they let their investments grow with the overall market. So, why learn about hedging?

Even if you never hedge for your own 澳洲幸运5开奖号码历史查询:portfolio, you should understand how it works. Many big companies and investment funds will hedge in some form. For example, oil companies might hedge against the price of oil. An international 澳洲幸运5开奖号码历史查询:mutual fund might hedge against fluctuations in foreign exchange rates. Having a basic unde🔥rstanding of hedging ca💟n help you comprehend and analyze these investments.

Example of a Forward Hedge

A classic example of hedging involves a wheat 𓆉farmer and the wheat futures market. A farmer plants their seeds in the spring and sells their harvest in the fall. In the intervening months, the farmer is subject to the price risk that wheat will be lower in the fall than it is now. While the farmer wants to make as much money as possible from their harvest, they do n🌠ot want to speculate on the price of wheat. So, when they plant their wheat, they can also sell a six-month futures contract at the current price of $40 a bushel. This is known as a forward hedge.

Suppose that six months pass and the farmer is ready to harvest and sell their wheat at the prevailing market price. The market price has indeed dropped to just $32 per bushel. They sell their wheat for that price. At the same time, they buy back their short futures contract for $32, which generates a net $8 profit. They therefore sell their wheat at $32 + $8 hedging profit = $40. They have essentially locked in the $40 price when they planted their crop.

Assume now that the price of wheat has instead risen to $44 per bushel. The farmer sells their wheat at that market price and repurchases their short futures for a $4 loss. Their net proceeds are thus $44 - $4 = $40. The farmer has limited their losses but also their gains.

The Bottom Line

Risk is an essential yet precarious element of investing. Rega🧜rdless of what kind of investor one aims to be, having a basic knowledge of hedging strategies will lead to better awareness of🧔 how investors and companies work to protect themselves.

Whether or not you decide to start practicing the intri🐽cate uses of derivatives, learning about how hedging works will help advance your understanding of the market, which will always help you be a better investor.

Correction—April 6, 2022: This article has been corrected to refer to th🌳e example of options hedging𓄧 as 30 shares sold.