# Hedge: Definition and How It Works in Investing

![Hedge](https://www.investopedia.com/thmb/2nOOW2a3WWr_zAc6d73kxpWMgiQ=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Investopedia-terms-hedge-fb11c495608344c395cafdb63213a1a7.jpg)

*Hedging reduces risk, but it doesn't eliminate it entirely. — Investopedia / Madelyn Goodnight*

> **Definition**
>
> A hedge is an investing strategy that aims to reduce risk by taking an opposite position in a related asset.

## What Is a Hedge?

Hedging is a strategy to limit investment risks. Investors hedge an investment by trading in another that is likely to move in the opposite direction. A [risk-reward tradeoff](https://www.investopedia.com/terms/r/riskreturntradeoff.asp) is inherent in hedging; while it reduces potential risk, it may chip away at potential gains.

### Key Takeaways

*   Hedging typically involves trading in derivatives, which can be effective because their relationship with their underlying assets is clearly defined.
*   Portfolio diversification is a type of hedge, such as when investors buy cyclical and countercyclical stocks.
*   Large financial entities and investment funds tend to engage in hedging practices.

## How a Hedge Works

Using a hedge is a bit like taking out an insurance policy. If you own a home in a flood-prone area, you can protect it from the risk of flooding—hedge it, in other words—by taking out flood insurance. You cannot eliminate the risk of a flood, but you can mitigate the financial losses you could incur.

Similarly, if you invest in a hot technology company with the firm belief that its business will thrive over the next quarters, you might also invest in a solid consumer staple stock just in case you're mistaken.

## The Downside to a Hedge

Hedging isn’t free. In the case of the flood insurance policy example, the monthly payments add up, and if the flood never comes, the policyholder gets nothing. Still, most people would choose to limit their losses.

In the world of professional investing, hedging works in the same way. Investors and money managers use hedging practices to reduce and control their [risk exposure](https://www.investopedia.com/terms/r/risk.asp). They use various tools for the purpose, many based on derivatives.

> **Fast Fact**
>
> A perfect hedge eliminates all risk in a position or portfolio. In other words, the hedge is 100% inversely correlated to the vulnerable asset. This is more an ideal than a reality, and even the hypothetical perfect hedge is not without cost.

## Hedging With Derivatives

Derivatives are financial contracts whose price depends on the value of an underlying security. Futures, forwards, and options contracts are common types of derivative contracts.

The effectiveness of a derivative hedge is expressed in terms of its [delta](https://www.investopedia.com/terms/d/delta.asp), sometimes called the hedge ratio. Delta is the amount that the price of a derivative moves per $1 movement in the price of the underlying asset.

The specific hedging strategy, as well as the pricing of hedging instruments, depends largely upon the downside risk of the underlying security against which the investor wants to hedge. Generally, the greater the downside risk, the greater the cost of the hedge.

Downside risk tends to increase with higher levels of volatility and over time; an option that expires after a longer period, which is linked to a volatile security, will be more expensive as a means of hedging.  

In general, the higher the strike price, the more expensive the put option will be, but the more price protection it will offer as well. These variables can be adjusted to create a less expensive option that offers less protection, or a more expensive one that provides greater protection.

## Example of Hedging With a Put Option

A common method for hedging is through put options. Puts give the holder the right, but not the obligation, to sell the underlying security at a pre-set price on or before the date it expires.

For example, if Morty buys 100 shares of PLC stock at $10 per share, and hedges the investment by purchasing a [put option](https://www.investopedia.com/terms/p/put.asp) with a [strike price](https://www.investopedia.com/terms/s/strikeprice.asp) of $8 expiring in one year. This option gives Morty the right to sell 100 shares of that stock for $8 per share anytime in the next year.

Let’s assume Morty pays $1 for the option, or $100 in premium. If the stock trades at $12 one year later, Morty will not exercise the option and will be out $100:

*   $1,000 for the stocks and $100 for the option = $1,100
*   Stock appreciates to $1,200
*   $100 lost by not exercising the option
*   But gains $100 ($1,200 - $1,000 paid for stock - $100 paid for option)

If the stock price fell to $0, Morty would exercise the option and sell the shares for $8, for a loss:

*   $1,100 for stocks and the option
*   Sold shares for $800
*   Total loss of $300

Without the option, Morty would have lost the entire investment of $1,000.

## Hedging Through Diversification

Strategically [diversifying](https://www.investopedia.com/articles/investing/030116/portfolio-diversification-done-right.asp) a portfolio to reduce certain risks can also be considered a hedge. For example, Rachel might invest in a luxury goods company with rising margins. She might worry, though, that a recession could wipe out the market for conspicuous consumption. One way to combat that would be to buy tobacco stocks or utilities, which tend to weather recessions well and pay hefty dividends.

This strategy has its tradeoffs: If wages are high and jobs are plentiful, the luxury goods maker might thrive, but few investors would be attracted to boring countercyclical stocks, which might fall as capital flows to more exciting places.

It also has its risks: There is no guarantee that the luxury goods stock and the hedge will move in opposite directions. They could both drop due to one catastrophic event, as happened during the financial crisis.

## Spread Hedging

For investors in index funds, moderate price declines are quite common and highly unpredictable. Investors focusing on this area may be more concerned with moderate declines than severe ones. In these cases, a [bear put spread](https://www.investopedia.com/terms/b/bearputspread.asp) is a common hedging strategy.

In this type of spread, the index investor buys a put that has a higher strike price. Next, they sell a put with a lower strike price but the same expiration date.

Depending on how the index behaves, the investor has a degree of price protection equal to the difference between the two strike prices (minus the cost). While this is likely to be a moderate amount of protection, it is often sufficient to cover a brief downturn in the index.

## Hedging and the Everyday Investor

Most individual investors don't trade derivative contracts. Investors with a long-term strategy, such as those saving for retirement, can ignore the day-to-day fluctuations of the markets.

For investors who fall into the buy-and-hold category, there may seem to be little or no reason to learn about hedging. Still, because large companies and investment funds tend to engage in hedging practices regularly, and because these investors might follow or even be involved with these larger financial entities, it's useful to understand what hedging entails to comprehend the actions of these larger players.

## What Do You Mean by Hedging?

Hedging is a strategy to limit investment risks. Investors hedge an investment by making a trade in another that is likely to move in the opposite direction.

## What Is an Example of Hedging?

Hedging is commonly used to offset potential losses in currency trading. A foreign currency trader who is speculating on the movements of a currency might open a directly opposing position to limit losses from price fluctuations. Thus, the trader retains some upside potential no matter what happens.

## How Do You Hedge in Trading?

Hedging is generally accomplished by purchasing options to minimize losses or investments that perform better when prices of the investments being hedged fall.

## The Bottom Line

Hedging is an important financial concept that allows investors and traders to minimize various risk exposures. A hedge is effectively an offsetting or opposite position taken that will gain (or lose) in value as the primary position loses (or gains) value.

A hedge can be thought of as a type of insurance policy on an investment or a portfolio. These offsetting positions can be achieved using closely related assets or through diversification.

Among professional traders, the most common and effective hedge uses derivatives such as futures, forwards, or options contracts.