Financial Dictionary -> Investing -> Hedge

Let us imagine that you are not an experienced investor who is reading this article just for fun but a beginner investor, who is cautious and inexperienced by default, and at the same time, wise in his choice of investment. How would you proceed? You monitor the market, notice the trends, even manage to get a little insider information - but yet something is still missing. Probably - position? Right, you take a position on the market, invest your hard-earned money, but something is still gnawing you. What if your position, despite your best efforts, takes the worst possible direction and the favored top-notch, A-class company's shares lose their position, while similarly rated B Company wins? Yes, you call your trader, or take the necessary steps yourself, in order to make a simple hedge which will help you restore or balance what you would lose if everything turned upside down.

By definition, hedge represents an investment which aims to lower the risk of possible downward price movements in the asset value. Normally, a hedge takes an offsetting position in a related security, such as futures contracts. A number of financial means and instruments exist in case that investors wish to offset a position in one market against price fluctuations in another, while aiming at risk management and minimization of losses. Some of the instruments include insurance policies, options, swaps, forward contracts, and last but not least, futures contracts (they represent standardized contracts which aim at trading a certain commodity of specified quality at a given point of time in the future. The price will be determined by the market).

Public futures markets were first established in the far 1800s for the provision of standardized and efficient hedging of agricultural commodity prices. At present, the scope of hedging has expanded to include future contracts on precious metals, energy prices, foreign currency and interest rates fluctuations. (Hedging includes multiple contracts, but one cannot normally hedge a Sunday church prayer contract with his wife by offsetting it with a couch-and-beer party.)

A classical type is hedging on the stock market. As already mentioned in the introductory paragraph, when a trader beliefs that a stock will rise over the next period, due to some favorable industrial indicators, he or she buys shares in Company A, guided by the belief that their price will rise. But the market is very turbulent, and the investor backs up his/her position by short selling an equal value of the direct competitor of A company (the formula multiples the number of shares by their price) - company B. During the second period, due to industrial and market changes, the shares of the first company go up, while the shares of company B rise in value, but to a lesser degree. Due to their short position, Company B's shares register loss for the trader, while prices for the industry grow up. However during the third period, the economy goes through a market crush. The long position of Company A will register loss while the short position of B's shares will compensate to some extent. In this manner, despite market fluctuations, long and short hedge positions allow for loss offsetting.