What Is a Short Hedge?
When an investor owns a security, he may worry about losing his money if the price of the investment falls. To protect himself from a loss, he can place a short hedge. This strategy allows him to earn a profit if the price of his primary investment declines.
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Hedging
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Hedging is a method investors use to protect themselves from losses on securities they already own. An investor engages in a short hedge by purchasing a contract that is profitable only if his primary investment declines in value. If the security doesn't decline, he doesn't exercise the contract. If it does decline, he exercises the contract to make up for the money he lost on the primary investment.
Example
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Assume an investor owns five shares of stock in Company A. If the investor is worried that the price of his stock will decline, he may place a short hedge by purchasing five "put options" for Company A stock that allow him to sell his shares for the current market price. If the price of the stock falls, he will exercise his option and recover his lost funds.
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Results
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When an investor places a short hedge by purchasing an option, there are three possible outcomes when the option matures -- the security price is higher, the price remains stable or the price is lower. If the price rises, the investor earns a profit on the primary investment but loses the money he paid for his hedge. If the security price remains stable, the investor doesn't gain or lose money on his primary investment, but he loses the cost of the hedge. If the security decreases, the investor loses money on his primary investment but earns a profit on the hedge.
Considerations
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The price of a short hedge reduces any profit an investor makes on his primary investment. Short hedging is also used in industry. For example, a manufacturer may short hedge by purchasing options that allow him to sell his products for a minimum price in the future. If the market value of his product declines, he exercises his option to prevent a loss. Investors can place long hedges by purchasing options that are profitable only when the price of a security increases.
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