Hedge, hedging

Hedge

What is hedging?

In finance and trading, hedging is a strategy to reduce the risk of being at the mercy of large market fluctuations in price.

To hedge against a loss from a price fluctuation, you usually open an off-setting position in a related security.

Investors and traders use hedging when they are unsure of which way the market will move. Ideally, hedging will slash any risk to zero or near zero, and cost only the broker's fee.

The hedge ratio compares either the value of a hedged position to the total size of the position or the value of a purchased futures contract to the value of the commodity being hedged.

De-hedging basically involves closing out any hedged positions you hold by returning to the markets when your underlying asset looks bullish and removing the hedge so you can profit from its rising price.

Options & futures example

You sold an 3-month call option for wheat and are worried that the price will increase significantly. As a hedge, you could buy a future on wheat that guarantees you an acceptable price in 3 months time.

Note that in this example, if the option would not be exerted, you would actually still need to buy the wheat in 3 months. This in turn is an example that hedging rarely is a "free lunch" and needs to be considered carefully.

Commodity hedge example

An airline wants to ensure it doesn't lose money on the seats it has sold because of rising oil prices. The airline could buy oil options or futures as a hedge. Even if it does not use the oil directly themselves (because they do not own a refinery), a rising oil price would earn them money on these trades, while costing them money in their operative business.

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