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.
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.