Definition
The term hedge refers to a strategy that establishes a new position in an asset to protect the profitability of an existing position. While a hedge can be used to control risk, and lower a potential loss, that same hedge will also reduce potential gains.
Explanation
A hedge is any position established by an investor that acts to lower their exposure and limit a potential loss if an existing position deteriorates. A hedge can take many different forms and can be used to protect stock portfolios, exchange traded funds (ETFs), derivatives, as well as futures contracts.
Hedges are sometimes negatively correlated to an existing position, meaning the value of the hedge moves in the opposite direction to the value of an asset the investor is trying to protect. Hedges can also be as simple as moving a portion of a portfolio out of equities and into cash. Other examples of hedges include:
Defensive Stocks: buying equities of companies that are tolerant to a downturn in the economy. Utilities and manufacturers of consumables, such as toothpaste and laundry detergent, are examples of defensive stocks. No matter how poor the economic conditions, people will continue to consume these products or services.
Inverse ETF: buying an exchange traded fund (ETF) that is constructed using derivatives that increase in value as the stock market declines.
Protective Puts: buying one put contract for every 100 shares of the underlying asset, or stock, the investor wishes to protect. Like other hedges, protective puts are a form of insurance. They provide the holder with a right, but not an obligation, to sell shares at the strike price at any time before the option's expiration date regardless of how low the stock's price declines.
Related Terms
The term hedge ratio refers to a mathematical formula that compares the value of a hedge to the value of the position in an asset. Calculating and tracking hedge ratios allows investors to understand and control their exposure to the price volatility of various assets.
Moneyzine EditorSeptember 20th, 2023
The term gamma refers to the rate of change in delta for a one point change in the price of an underlying asset. An option's gamma is typically expressed in terms of a percentage change in delta for a one-point change in the underlying asset's price.Moneyzine EditorJanuary 19th, 2024
The term fungibility refers to the interchangeability of assets due to standardization. Trading and exchange of an asset is simplified if it possesses the characteristic of fungibility.Moneyzine EditorNovember 6th, 2024
The term expiration Friday refers to the last business day an option can be sold, purchased, or exercised before it expires. Expiration Friday occurs each quarter, and is characterized by higher than normal price volatility and trading volumes.Moneyzine EditorNovember 6th, 2024
The term expiration date refers to the final day the holder of an option contract can exercise their right under the agreement. After the expiration date, the seller of an option can no longer be assigned.Moneyzine EditorNovember 6th, 2024
The term exercise by exception refers to the automatic exercise of in-the-money options at expiration. The Options Clearing Corporation (OCC) institutes exercise by exception unless explicit instructions prohibit exercising the option.Moneyzine EditorNovember 6th, 2024
The term European option refers to an agreement that can be exercised only on a specific day prior to its expiration date. Call or put options involving stock market indexes are typically European-style options.Moneyzine EditorNovember 6th, 2024
The term American option refers to an agreement that can be exercised at any time prior to, and including, its expiration date. Call or put options involving equities or common stock are typically American-style options.Moneyzine EditorNovember 6th, 2024
