A hedge is a risk management strategy used by investors and traders to offset potential losses in one investment by taking an opposite position in another investment. The goal of hedging is to protect against adverse market movements and reduce the overall risk in a portfolio.
For example, let’s say you own 100 shares of Company XYZ, and you are concerned that the stock price may decline in the near future. You could purchase a put option on Company XYZ, which gives you the right to sell the shares at a predetermined price (the strike price) within a specified time frame. If the stock price does indeed decline, the put option will increase in value and offset some of the losses on your stock position.
Hedging can be done using a variety of financial instruments such as options, futures contracts, and exchange-traded funds (ETFs). However, hedging is not a perfect strategy and can have drawbacks such as additional costs and reduced potential gains if the market moves in the expected direction. Traders and investors should carefully consider their risk tolerance and investment objectives before implementing a hedging strategy.