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In the investment world, hedging is the practice of offsetting potential losses on one asset with potential gains in another.
Understanding a hedge
A hedge is an investment that seeks to offset potential losses on one asset with potential gains in another asset. The purpose is to ensure that if one asset fails, another asset – which is unlikely to move in parallel with the first asset – can offset the loss. There are many hedging strategies, and all of them are about reducing risk. Although more sophisticated hedging methods are available to some investors, there is no perfect hedge that completely eliminates risk.
Suppose you invest a large sum of money in the fictitious company Frankie’s Foghorns. You expect the company’s stock price to rise. However, since you’ve invested a lot, you want to hedge in case the stock price goes down instead. To mitigate the risk of your investment in Frankie’s Foghorns, you buy a put option that gives you the right to sell your stock at the strike price. The put option is your hedge, limiting the downside risk of a falling stock price.
You hedge for the same reason you purchase an insurance policy…
If you own a car, you usually take out insurance to cover losses due to possible accidents. If you suffer a loss in value because the car is totaled, you expect the insurance company to write you a check to cover the loss. Similarly, coverage can offset the loss of value of an asset.