Re: What is hedging? How does it work...?What is a hedge?
Insurance is an investment that helps limit your financial risk. Hedging works by holding an investment that will move in the opposite direction of your original investment, so if the main investment goes down, the investment hedge will offset or limit the overall loss.
Hedging comes in many forms and includes the use of derivatives such as options to limit your risk, as well as less complex assets such as cash. Some investors use short selling to hedge their specific risks and set up their portfolios to profit when the market declines.
How does Hedging work?Hedging can take many different forms, but one of the most common ways to hedge is through the use of 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 losing the underlying asset you want to hedge . It works like this. Let's say you bought a stock at $100 per share, but you're worried that an upcoming earnings announcement could disappoint investors and cause the stock to crash. One way to limit your exposure to this potential loss is to buy a put option on the stock with a strike price that you are comfortable with. A put option with a strike price of $95 allows 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 drop 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 make a $10 profit from the increase in the stock price when the option expires worthless. Your net profit will be $10 per share after the option price
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 you if things don't go as you expect. Limit Losses – Hedging allows you to limit your losses to an amount that suits you. The hedging price will limit your growth, but you can be sure that your losses will not increase if the price falls. Price certainty – Companies and individuals such as farmers also use derivatives to remove uncertainty about future commodity prices. Using futures and forward contracts, they can lock in the prices of key commodities well in advance of their delivery date.
Insurance is an investment that helps limit your financial risk. Hedging works by holding an investment that will move in the opposite direction of your original investment, so if the main investment goes down, the investment hedge will offset or limit the overall loss.
Hedging comes in many forms and includes the use of derivatives such as options to limit your risk, as well as less complex assets such as cash. Some investors use short selling to hedge their specific risks and set up their portfolios to profit when the market declines.
How does Hedging work?Hedging can take many different forms, but one of the most common ways to hedge is through the use of 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 losing the underlying asset you want to hedge . It works like this. Let's say you bought a stock at $100 per share, but you're worried that an upcoming earnings announcement could disappoint investors and cause the stock to crash. One way to limit your exposure to this potential loss is to buy a put option on the stock with a strike price that you are comfortable with. A put option with a strike price of $95 allows 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 drop 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 make a $10 profit from the increase in the stock price when the option expires worthless. Your net profit will be $10 per share after the option price
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 you if things don't go as you expect. Limit Losses – Hedging allows you to limit your losses to an amount that suits you. The hedging price will limit your growth, but you can be sure that your losses will not increase if the price falls. Price certainty – Companies and individuals such as farmers also use derivatives to remove uncertainty about future commodity prices. Using futures and forward contracts, they can lock in the prices of key commodities well in advance of their delivery date.
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