Hedge your risk™–old-fashioned financial management leads with a sale; we lead with an understanding of your needs and risk tolerance to protect your hard-earned money from panic.
A hedge investment offsets the risk of adverse price movements in another investment. A perfect hedge is hard to find, but it’s one that is 100% inversely correlated to the original investment. If the original investment depreciates the hedge investment rises. Hedging is like taking out an insurance policy. The downside of hedging to reduce risk is that it often reduces potential profits as well.
Suppose Rachel buys shares of a luxury goods company. She knows its profits will fall when the economy slows, so she diversifies. Rachel hedges with a defensive stock such as a utility company which isn’t vulnerable to changes in the economy. If the economy tanks and the value of the luxury goods stock do indeed fall the utility stocks offer some protection. If the economy booms, Rachel may wish she had used her money to buy more luxury goods stocks rather than hedging.
Derivatives are a popular instrument to hedge against an underlying asset. For example, Monty the investor buys 100 shares of stock PLC at $10 a piece. Monty hedges by buying a $5 put option on the stock with a strike price of $8 that expires in a year. If the stock trades above the strike price, monty won’t exercise his option. If the stock trades at $0, monty will sell his shares at $8 each, costing him $205. Without the option, monty stood to lose his entire investment.