A hedge or ‘Hedging’ against investment risk means to strategically use instruments in the market to offset the risk of fluctuations in the price of an asset. In other words, an investor can hedge one of their investments by making another investment. To hedge one has to invest in two securities with negative correlations.
Understanding a Hedge
The best way one can understand Hedging is to think of it as a kind of insurance. For instance, whenever a person decides to hedge they are basically insuring themselves against the possibility of a negative event that would result in their loss. While this does not prevent a negative event from happening, it does however reduce the impact of the negative impact, that is, if the investor is properly hedged. A good example of this is when a person gets their house insured, they are actually hedging themselves against all the things that could happen to their property that would result in their loss, such as, fires, break-ins and any other disasters that may strike. Hedging techniques are normally used by investors, portfolio managers and corporations to reduce the amount of risk in each investment.
How do Investors Hedge?
Hedging is a technique that brings in to play complex financial instruments that are called ‘derivatives.’ Two of the most common type of derivates are futures and options. With time, investors are able to use options and futures in order to develop effective trading strategies where their losses can be limited. But, every hedge has a cost, which is why it is important to ask yourself if the benefits that you receive justify the expenses.
One thing to keep in mind is that the cost of the hedge whether its lost profits from being on the wrong side of a deal or the cost of an option cannot be avoided. This is the price that every investor has got to pay to avoid uncertainty. That being said, risk is an essential element of making an investment regardless of what you are investing in. But, knowledge of hedging strategies can lead you towards a better awareness and lowered risk.
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