What is a hedge?
A hedge is an investment that helps limit your financial risk. A hedge works by holding an investment that will move in the opposite direction of your original investment, so that if the principal investment declines, the investment hedge will offset or limit the overall loss.
Hedges come in many forms and include using derivatives like options to limit your risk, as well as less complex assets like cash. Some investors use short selling to hedge their specific risks and set their portfolios up to profit in the event of a market decline.
How Hedging Works?
Hedging can take many different forms, but one of the most common ways to hedge is by using derivatives, which derive their value from an underlying asset such as a stock, commodity or index such as the S&P 500. You can directly limit your risk of loss to the underlying asset that you want to hedge. Here's how it works.Say you bought a stock at $100 per share, but worry that an upcoming earnings announcement could disappoint investors and send the stock tumbling. One way to limit your exposure to that potential loss is to buy a put option on a stock with a strike price that suits you. A put option with a strike price of $95 will allow you to sell the stock at $95, even if the stock falls below that level.
Here's what can happen if the stock goes up or down?
If the stock falls to $80 per share, you will be able to exercise your put option at $95. The hedge perfectly protects your stock investment from a fall from $95 to $80, so your loss is limited to $5 per share ($100 – $95) plus the value of the option.If the stock rises to $110 per share, you will realize a $10 gain from the increase in stock price, when the option expires worthless. Your net gain will be $10 per share after the cost of the option
Advantages of hedging:
Risk Reduction – The main benefit of hedging is the ability to manage the risk and investment exposure you have. Derivatives can be used to protect yourself if things don't go as you expect.Limit losses – Hedging allows you to limit your losses to an amount that suits you. The price of the hedge will limit your upside, but you can be sure that your losses won't balloon in the event of a price drop.Price certainty – Companies and individuals such as farmers also use derivatives to remove uncertainty of future commodity prices. By using futures and forward contracts, they can lock in the prices of key commodities well in advance of their delivery dates.
A hedge is an investment that helps limit your financial risk. A hedge works by holding an investment that will move in the opposite direction of your original investment, so that if the principal investment declines, the investment hedge will offset or limit the overall loss.
Hedges come in many forms and include using derivatives like options to limit your risk, as well as less complex assets like cash. Some investors use short selling to hedge their specific risks and set their portfolios up to profit in the event of a market decline.
How Hedging Works?
Hedging can take many different forms, but one of the most common ways to hedge is by using derivatives, which derive their value from an underlying asset such as a stock, commodity or index such as the S&P 500. You can directly limit your risk of loss to the underlying asset that you want to hedge. Here's how it works.Say you bought a stock at $100 per share, but worry that an upcoming earnings announcement could disappoint investors and send the stock tumbling. One way to limit your exposure to that potential loss is to buy a put option on a stock with a strike price that suits you. A put option with a strike price of $95 will allow you to sell the stock at $95, even if the stock falls below that level.
Here's what can happen if the stock goes up or down?
If the stock falls to $80 per share, you will be able to exercise your put option at $95. The hedge perfectly protects your stock investment from a fall from $95 to $80, so your loss is limited to $5 per share ($100 – $95) plus the value of the option.If the stock rises to $110 per share, you will realize a $10 gain from the increase in stock price, when the option expires worthless. Your net gain will be $10 per share after the cost of the option
Advantages of hedging:
Risk Reduction – The main benefit of hedging is the ability to manage the risk and investment exposure you have. Derivatives can be used to protect yourself if things don't go as you expect.Limit losses – Hedging allows you to limit your losses to an amount that suits you. The price of the hedge will limit your upside, but you can be sure that your losses won't balloon in the event of a price drop.Price certainty – Companies and individuals such as farmers also use derivatives to remove uncertainty of future commodity prices. By using futures and forward contracts, they can lock in the prices of key commodities well in advance of their delivery dates.