Hedging is considered an advanced investing strategy, but the principles are fairly simple. With the popularity of hedge funds, the practice of hedging is becoming more widespread but still not widely understood.
Most people have engaged in hedging. Taking out insurance to minimize the risk that injury will erase your income or to support your family in the case of your death is a hedge. You pay monthly sums for the coverage provided by an insurance company. Although the textbook definition of hedging is an investment taken out to limit the risk of another investment, insurance is an example of a real-world hedge.
Hedging, in the Wall Street sense of the word, is best illustrated by an example.
Suppose you want to invest in bungee cord manufacturing. A company called Plunge is transforming the materials and designs to make cords that are twice as good as its nearest competitor, Tumble, so you think that Plunge’s share value will rise over the next month.
Unfortunately, the bungee cord manufacturing industry is always susceptible to sudden changes in regulations and safety standards, meaning it is quite volatile. This is called industry risk. Despite this, you believe in this company and you want to find a way to reduce the industry risk. In this case, you hedge by going long on Plunge while shorting its competitor, Tumble. The value of the shares involved will be €1,000 for each company.
If the industry as a whole goes up, you make a profit on Plunge, but lose on Tumble – hopefully for a modest overall gain. If the industry takes a hit, for example if someone dies bungee jumping, you lose money on Plunge but make money on Tumble.
Your overall profit, the profit from going long on Plunge, is minimized in favour of less industry risk. This is sometimes called a pairs trade and it helps investors gain a foothold in volatile industries or find companies in sectors that have some kind of systematic risk.
Hedging is a valid strategy that can help protect your portfolio, home and business from uncertainty.