Hedging is when investors take necessary steps to protect themselves from unforeseeable events in relation to their investments.
In the financial markets, hedging takes place when investors and portfolio managers employ various techniques to protect their investments or their client’s investments to reduce the risks. Hedging is the strategic use of different instruments in the market to lessen the risk of any negative price movements of an asset or security.
Many people think that hedging only takes place in financial markets. This is a misconception as hedging even takes place in people’s everyday lives. Many individuals take precautions in protecting their assets, after all.
Examples of everyday hedging are life insurances or car insurances among others. Individuals who invest on life insurance want to ensure that their families will still receive income in cases where the insured dies or becomes too disabled to work and earn. Individuals also buy car insurances to ensure that they can claim some financial assistance to cover the costs of damages to the car in cases of fortuitous events.
Hedging in financial markets
Hedging in the financial markets required the purchases of two securities that have negative correlations.
For example, an investor may want to invest in one stock that is considered volatile (stock A). The investor will need to purchase a similar stock that is similar but has a negative correlation to the stock the investor wants to buy (stock B), in order to offset the risks of purchasing the said stock.
It means that the investor has two stocks that perform differently in the market. For example, if stock A does well in the market then, stock B will have a different performance and vise versa. Such move offsets the risks of buying a particular stock.
Hedging is not exactly a move intended to increase profits, but is an undertaking to lessen possible losses.