Hedging: Principles

We’ve all heard the phrase hedging your bets and in finance this means the same.

Hedging is used by banks, energy companies and hedge funds, to name a few. Of course in the case of latter, whilst the term is in its name, this does not necessarily mean hedge funds employ sufficient hedging. Hedges reduce risk arising from their exposure to factors such as, supply and demand or volatility.

According to Wikipedia,

A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.

In financial markets, however, hedging becomes more complicated than simply paying an insurance company a fee every year. Hedging against investment risk means strategically using instruments in the market to offset the risk of any adverse price movements. In other words, investors hedge one investment by making another.

Hedging, in the Wall Street sense of the word, is best illustrated by example. Imagine that you want to invest in the budding industry of bungee cord manufacturing. You know of a company called Plummet that is revolutionizing the materials and designs to make cords that are twice as good as its nearest competitor, Drop, so you think that Plummet’s share value will rise over the next month.

Unfortunately, the bungee cord manufacturing industry is always susceptible to sudden changes in regulations and safety standards, meaning it is quite volatile. This is called industry risk. Despite this, you believe in this company and you just want to find a way to reduce the industry risk. In this case, you are going to hedge by going long on Plummet while shorting its competitor, Drop. The value of the shares involved will be $1,000 for each company.

If the industry as a whole goes up, you make a profit on Plummet, but lose on Drop – hopefully for a modest overall gain. If the industry takes a hit, for example if someone dies bungee jumping, you lose money on Plummet but make money on Drop.

Basically, your overall profit, the profit from going long on Plummet, is minimized in favor of less industry risk. This is sometimes called a pairs trade and it helps investors gain a foothold in volatile industries or find companies in sectors that have some kind of systematic risk. (To learn more, read the Short Selling tutorial)

Hedging is often unfairly confused with hedge funds. Hedging, whether in your portfolio, your business, or anywhere else, is about decreasing or transferring risk. Hedging is a valid strategy that can help protect your portfolio, home and business from uncertainty.

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