Hedging in trading and finance is a risk management strategy used to limit or offset potential losses that may be incurred due to price fluctuations in an asset. It involves taking an opposite position in a related security.
For example, if you own shares of a company and you’re worried that the price might drop, you can “hedge” your investment by purchasing a financial instrument known as a put option, which increases in value as the share price falls. In this way, if the share price of the company drops, the profit from the put option can offset the loss in the shares.
Hedging is a common practice in a variety of markets including stocks, commodities, forex, and derivatives. There are several methods to hedge in investment, and it’s typically performed through the derivatives market (options, futures, etc).
However, it’s important to note that hedging isn’t about making money, it’s about protecting against losses. The cost of the hedge – whether it is the cost of an option or lost profits from being on the wrong side of a futures contract – can be considered an insurance premium.
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