What It Is:
In finance, a hedge is a strategy intended to protect an investment or portfolio against loss. It usually involves buying securities that move in the opposite direction than the asset being protected.
How It Works/Example:
Let's assume part of your investment portfolio includes 100 shares of Company XYZ, which manufactures autos. Because the auto industry is cyclical (meaning Company XYZ usually sells more cars and is more profitable during economic booms and sells fewer cars and is less profitable during economic slumps), Company XYZ shares will probably be worth less if the economy starts to deteriorate. How do you protect your investment?
One way is to buy defensive stocks. These stocks might be from the food, utility, or other industries that sell products that consumers consider basic necessities. During economic slumps, these stocks tend to gain or at least hold their value. Thus, these stocks may gain when your XYZ shares lose.
Why It Matters:
Hedging is like buying insurance. It is protection against unforeseen events, but investors usually hope they never have to use it. Consider why almost everyone buys homeowner's insurance. Because the odds of having one’s house destroyed are relatively small, this may seem like a foolish investment. But our homes are very valuable to us and we would be devastated by their loss. Using options to hedge your portfolio essentially does the same thing. Should a stock or portfolio take an unforeseen turn, holding an option opposite of your position will help to limit your losses.
Portfolio hedging is an important technique to learn. Although the calculations can be complex, most investors find that even a reasonable approximation will deliver a satisfactory hedge. Hedging is especially helpful when an investor has experienced an extended period of gains and feels this increase might not be sustainable in the future. Like all investment strategies, hedging requires a little planning before executing a trade. However, the security that this strategy provides could make it well worth the time and effort.