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Hedging is the practice of purchasing and holding securities
specifically to reduce portfolio risk. These securities are intended to move in
a different direction than the remainder of the portfolio - for example,
appreciating when other investments decline. A put option on a stock or index
is the classic hedging instrument Options are a great way to hedge against your
existing positions to decrease risk
When properly done, hedging significantly reduces the uncertainty
and the amount of capital at risk in an investment, without significantly
reducing the potential rate of return.
Hedging is what separates a professional from an amateur trader. Hedging is the
reason why so many professionals are able to survive and profit from stock and
option trading for decades
Downside Risk
The pricing of hedging instruments is related to the potential downside
risk in the underlying security. As a rule, the more downside risk the
purchaser of the hedge seeks to transfer to the seller, the more expensive the
hedge will be.
Spread Hedging
Index investors are often more concerned with hedging against moderate price
declines than severe declines, as these type of price drops are both very
unpredictable and relatively common.
The Bottom Line
Hedging can be viewed as the transfer of unacceptable risk from a portfolio
manager to an insurer. This makes the process a two-step approach
