What is hedging?

Hedging is the process that is used to reduce risk of loss against negative outcomes within the stock market. Hedging is a similar concept to home insurance, where you might protect yourself against negative outcomes by purchasing fire and peril insurance. The only difference with hedging is that you are insuring against market risks and you are never fully compensated for your loss. This occurs when one investment is hedged through the purchase of another investment.

Those most likely to hedge are individual investors, corporations and portfolio managers. Although there is no way to completely eliminate market risk, hedging can reduce that risk.

Options and futures trading

The two most common forms of hedging are options and futures. An option gives a buyer the right to buy and sell assets at a set price on or before a prescribed date. There is no obligation under options. Futures are the legal agreement form of options. That is, under futures, there is a legal arrangement to buy and sell on a predetermined date. This must happen when specified in the futures contract.

The benefits of hedging: financial risk management and limiting loss

Hedging is most useful under the following circumstances:

• Those who have commodity investment that are subject to price movements can use hedging as a risk management technique

• Hedging helps set a price level for purchase or sale of an asset prior to that transaction occurring

• Hedging also makes it possible to experience gains from any upward price fluctuations to protect against downward price movements.

The negatives of hedging: associated costs and returns

On the other hand, there are some negatives associated with hedging:

• Hedging is expensive and the gains you stand to make from hedging may not exceed the cost of hedging itself

• Hedging never results in the recovery of all your loss and, despite the best efforts of risk managers, you can never predict exactly how the decision to hedge will pan out. Therefore, hedging, like the market itself, is not an exact gamble. There is some guesswork involved.