Hedging is a risk management strategy used to offset potential losses in an investment by taking an opposite position in a related asset. Traders use hedging to protect their capital against adverse price movements rather than to generate speculative profit. If a trader owns shares in a company, they might purchase put options on that same stock. If the stock price falls, the put option gains value, which helps mitigate the losses on the original shareholding.
Common hedging instruments include options, futures contracts, and inverse exchange traded funds. For example, a gold miner might sell futures contracts to lock in a specific selling price for their output, protecting them against future price drops. While hedging reduces exposure to market volatility, it also limits potential gains because the cost of the hedge acts as a drag on overall performance. Hedging requires careful calculation of correlation between assets to ensure the protection is effective. Trading involves significant risk, and hedging strategies do not guarantee a profit or prevent all losses. Investors should understand that hedging is a defensive tool designed to preserve capital in uncertain market conditions.
How this answer was produced
AI-assisted draft, human-reviewed by AlphaScala editorial against our standards before publication. General education, not advice for your specific situation.