A hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment. Hedging can be constructed from many types of financial instruments, which includes: stocks, exchange-traded funds, and insurance, forward contracts, swaps, options, various types of over-the-counter and derivative products, and futures contracts.
Hedging is a practice every investor should know about. To make it simple, Hedging is used to reduce any substantial losses o gains suffered by an individual or an organization. Hedging can be thought of as insurance, when people decide to hedge—they are insuring themselves against a series of undesirable events.
Though Hedging can’t be considered as something that prevents negative events from happening, but it can be of help especially when it comes to effect of a certain negative event; if an investor is properly Hedged, as well as knowing the advantages and how Hedging works, the impact of a certain unfortunate event could be reduced.
As being said, Hedging can be considered as insurance. For example, if a person buys a house insurance—he or she is hedging him or herself against fires, break-ins, and other unforeseen disasters.
How Hedging Works
Though Hedging is mostly used to reduce an investor or corporation’s exposure to risks, it is very different and more complicated when it comes to the financial markets. Hedging against investment risk means strategically using instrument market instruments to equipoise the risk of any adverse price movements. To make it simple: investors hedge one investment by making another.
In addition to this, Hedging is a financial management strategy used in limiting or offsetting probability of loss from fluctuations on prices and commodities, currencies and even securities.
However, every hedge has a cost, making hedging a decision that should be contemplated thoroughly. Before an investor decides to use Hedging, he or she must ask him or herself if the benefits received from it justify the expense. 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, cannot be avoided. This is the price an investor should have to pay to avoid uncertainty.
Uncertain events of losses are inevitable, especially inside the market. Having a basic knowledge of Hedging strategies will lead to a better awareness of how investors and companies work to protect themselves. Remember that the main goal of Hedging is not to make money but to protect an investment from losses; learning about how Hedging works will help advance an investor’s understanding of the market—and hence, will make you a better investor.