what is hedging

Hedging is minimizing risk as much as possible. There are many different ways of hedging, depending on the asset in question.

Let's take wheat as an example. The farmer wants to lock in a particular price for wheat. The farmer's objective is to remove the uncertainty over what his/her wheat will sell for when it's time to harvest it. In this case, a futures contract on wheat is a good hedge. A futures contract, as you may know, is an agreement between a buyer and seller which says that the buyer will buy a specified amount of wheat at a specific price on a set date. In this fashion, the wheat farmer can eliminate uncertainty over what the wheat will be worth in the future.

Now let's take stock as an example. A common way of hedging stock is to buy options. A stock option contract gives the buyer the right to buy or sell a specific number of shares of stock on or by an expiration date. A call is a right to buy and a put is a right to sell. An options contract has a buyer and seller. The buyer has the right to buy or sell. The seller has the OBLIGATION to deliver/purchase stock. Hedging stock with options is very complicating but I will describe a common scenario to you. Many investors buy stock and then buy put options on the same stock. A put option is a right to sell stock at a specified price, known as the strike price. Usually, options contracts involve blocks of 100 shares of stock. Therefore, a common way of hedging stock with put options is for the investor to buy 100 shares of stock. By buying 100 shares of stock, the investor makes a profit only if the price goes up. This is called going long. Subsequently, the investor can buy a put option on that same stock. If the price goes down, the investor can exercise the put option and sell the shares of stock under the terms of the put option, effectively canceling out the loss on the long position.

The above scenarios are examples of hedging. The problem is that hedging is very complicated for individual investors. Options contracts are incredibly expensive, running into the tens of thousands of dollars. An alternative to this is short ETFs. These ETFs go short on some index, such as the S&P 500. If you buy into this ETF, you can indirectly hedge your portfolio. Another "hedge" is to have some of your portfolio in fixed income, i.e. bonds. This is an "imperfect hedge" for your portfolio. Typically, when stocks go down, bonds go up so if you have some of your portfolio in bonds, it is possible to provide a cushion.

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