What does "hedge" mean? (January 6, 2003)

  Think of the old phrase 'hedge your bets'. When you hedge you are taking steps to mitigate the risk in the event you are wrong. There are many ways to hedge based on what type of investment made and what type of risk you are concerned about. One of the most common in the investment world is seen with mutual funds buying puts at certain times to manage the downside risk. Mutual funds try to avoid continually buying into and selling out of positions as it logistically it is difficult to do this on the QT and it also can burn up the fund performance in the transaction costs associated with huge amounts of stock. They prefer to buy and hang on as long as feasible. When they are concerned about the market selling, they will purchase protective puts to hedge. If their stock positions decline in value the put will rise in value, offsetting to a certain extent the drop in stock price. This way the funds can avoid having to sell out on each market drop (at least for awhile). It is very similar to credit spreads where you sell one option and buy the other; the option bought acts as insurance if the position moves against you.

There are many other types of hedging with different instruments. The above was just one common method.


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