Hedging is a financial strategy used to reduce the risk of investing in financial markets. Like insurance, hedging can avoid some losses, but it also may reduce some potential for returns on investment. An investor who believes he can make a profit on the increase in value of an investment will reduce potential losses by betting on the decline of a related investment.
Short selling is essential to any financial hedging. It allows an investor to make money from the decline of a stock or commodity rather than an increase in value. If an investor believes that a particular stock is overpriced, she can sell some shares to another individual with a contract to repurchase it in the future. If the stock value declines and the investor then chooses to buy it back, the difference in price is profit. Conversely, if the stock becomes more expensive during that time, the difference in price is a loss.
The easiest way to learn how hedging works is through example. Assume that an investor believes the stock of a particular soft drink company, Cola Products, is going to rise. But he is concerned about a potential increase in certain soft drink ingredients. He can hedge the bet on Cola Products against the soft drink industry at large. The investor would purchase the stock of Cola Products and short sell the stocks of several other soft drink companies. If Cola Products stock rises and little takes place in the general soft drink industry, the investor made money on Cola Products and broke even on their short sales. If certain soft drink ingredients become more expensive and stocks decline throughout the industry, the investor has lost money on Cola Products but earned a profit on the short sales.
In practice, hedging is much more complicated than the example above. Investors often use complex mathematical models to decide which investments to hedge and with how much money. Hedging does not always take place with stocks. For instance, if the investor above believed that Cola Products stock might decline due to an increase in the price of corn syrup, he could short sell corn syrup futures. Hedging also takes place in currency exchange markets.
Hedge funds operate similarly to mutual funds. Individuals and institutions can invest in hedge funds, named so because they attempt to turn a profit by hedging investments using the strategies discussed above. However, the federal government regulates hedge funds less than mutual funds and offers less protections to investors.
Hedge Fund Risks
Hedge funds, unlike mutual funds, are not required to disclose all of their investments to investors. Though all funds that service more than 15 domestic clients or manage more than $150 million in assets must register with the SEC and disclose fund information, the main purpose there is to allow the SEC to measure systemic risk and deter the chances of fraud. The SEC suggests that individuals fully research funds and consider their risk tolerance before investing.