What is Hedging?
One of the simplest ways to explain this technique is to compare it to insurance; in fact insurance is technically a form of hedging. If you take insurance out on something that you own: such as a car, house, or household contents, then you are basically protecting yourself against the risk of loss or damage to your possessions. You incur the cost of the insurance premium so that you will receive some form of compensation if your possessions are lost, stolen, or damaged, thus limiting your exposure to risk.
Hedging in investment terms is essentially very similar, although it's somewhat more complicated that simply paying an insurance premium. The concept is in order to offset any potential losses you might experience on one investment, you would make another investment specifically to protect you.
For it to work, the two related investments must have negative correlations; that's to say that when one investment falls in value the other should increase in value. For example, gold is widely considered a good investment to hedge against stocks and currencies. When the stock market as a whole isn't performing well, or currencies are falling in value, investors often turn to gold, because it's usually expected to increase in price under such circ*mstances.
Because of this, gold is commonly used as a way for investors to hedge against stock portfolios or currency holdings. There are many other examples of how investors use hedging, but this should highlight the main principle: offsetting risk.
Why Do Investors Use Hedging?
This isn't really an investment technique that's used to make money, but it's used to reduce or eliminate potential losses. There are a number of reasons why investors choose to hedge, but it's primarily for the purposes of managing risk.
For example, an investor may own a particularly large amount of stock in a specific company that they believe is likely to go up in value or pay good dividends, but they may be a little uncomfortable about their exposure to risk. In order to still benefit from any potential dividend or stock price increase, they could hold on to the stock and use hedging to protect themselves in case the stock does fall in value.
Investors can also use the technique to protect against unforeseen circ*mstances that could potentially have a significant impact on their holdings or to reduce the risk in a volatile investment.
Of course, by making an investment specifically to protect against the potential loss of another investment you would incur some extra costs, therefore reducing the potential profits of the original investment. Investors will typically only use hedging when the cost of doing so is justified by the reduced risk. Many investors, particularly those focused on the long term, actually ignore hedging completely because of the costs involved.
However, for traders that seek to make money out of short and medium term price fluctuations and have many open positions at any one time, hedging is an excellent risk management tool. For example, you might choose to enter a particularly speculative position that has the potential for high returns, but also the potential for high losses. If you didn't want to be exposed to such a high risk, you could sacrifice some of the potential losses by hedging the position with another trade or investment.
The idea is that if the original position ended up being very profitable, then you could easily cover the cost of the hedge and still have made a profit. If the original position ended up making a loss, then you would recover some or all of those losses.
How to Hedge Using Options
Using options for hedging is, relatively speaking, fairly straightforward; although it can also be part of some complex trading strategies. Many investors that don’t usually trade options will use them to hedge against existing investment portfolios of other financial instruments such as stock. There a number of options trading strategies that can specifically be used for this purpose, such as covered calls and protective puts.
The principle of using options to hedge against an existing portfolio is really quite simple, because it basically just involves buying or writing options to protect a position. For example, if you own stock in Company X, then buying puts based on Company X stock would be an effective hedge.
Most options trading strategies involve the use of spreads, either to reduce the initial cost of taking a position, or to reduce the risk of taking a position. In practice most of these options spreads are a form of hedging in one way or another, even this wasn't its specific purpose.
For active options traders, hedging isn't so much a strategy in itself, but rather a technique that can be used as part of an overall strategy or in specific strategies. You will find that most successful options traders use it to some degree, but your use of it should ultimately depend on your attitude towards risk.
Summary
For most investors, a basic comprehension of hedging is perfectly adequate, and it can help any investor understand how options contracts can be used to limit the risk exposure of other financial instruments. For anyone that is actively trading options, it's likely to play a role of some kind.
However, to be successful in options trading it's probably more important to understand the characteristics of the different options trading strategies and how they are used than it is to actually worry specifically about how hedging is involved.
