If you work in Finance or are learning how to, the term “hedging” is one that you should be aware of. In the stock market, hedging is a way to get portfolio protection which is often just as important as portfolio appreciation.
Here’s what you need to know about Hedging in Finance, including what exactly it means and how it works.
What is Hedging in Finance?
Hedging is a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset. In simpler terms, when investors decide to hedge, they are insuring themselves against a negative event’s impact on their finances.
It’s important to note that this doesn’t prevent a negative financial event from happening. However, if one does happen, hedging funds prevents the event from having a serious and strenuous effect on your finances/investment. For example, if you buy homeowner’s insurance, you are hedging yourself against fires, break-ins, or other unexpected disasters.
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How To Hedge an Investment
Hedging against investment risks means strategically using financial strategies to offset the risk of any adverse price movements. Basically, investors hedge one investment by making a trade in another.
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.
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Furthermore, hedging techniques generally involve the use of derivatives. Two of the most common derivatives are options and futures. Derivatives allow you to develop trading strategies where a loss in one investment is offset by a gain in a derivative. For example, if you were to hold stock in a company, but want to offset any drop in your investment, you can place an option on the purchase to resell at a fixed price.
Therefore, if your total investment drops below that price, you can sell the investment back at that fixed price and save some of your investment. This strategy is known as a married put.
Since there are many different types of options and futures contracts, an investor can hedge against nearly anything.