Glossary
Hedge
A position taken to offset the risk of another, such as buying a put option to protect a stock holding against a fall.
A hedge is an investment made to reduce the risk of another position: when the original holding loses value, the hedge is expected to gain, or at least to lose less. Farmers hedge crop prices with futures, airlines hedge fuel costs, exporters hedge currencies, and investors hedge portfolios with options or short positions. A hedge is insurance, so it has a cost: it lowers potential losses at the price of some combination of fees, premiums and reduced upside.
How it works
The hedge needs to move opposite to the exposure being protected, and it needs to be sized correctly. The share of the exposure covered is the hedge ratio.
Common hedging tools
- Options: puts as a floor, or collars (buy a put, sell a call) to cut the cost.
- Futures and forwards: lock in a price for a commodity, index or currency.
- Short positions in a related stock, sector ETF or index.
- Diversification across assets that do not move together, a loose, low-cost form of hedging.
What to watch for
- Basis risk. A hedge that is close but not identical, such as an index put protecting a single stock, can fail when the two diverge.
- Cost drag. Rolling protection continuously can cost several percent a year.
- Over-hedging turns protection into a speculative bet in the other direction.
- Correlations change in a crisis, sometimes making a hedge less effective exactly when it is needed.