In financial term, hedge is a strategy intended to protect an investment or portfolio against loss. It usually involves buying securities that move in the opposite direction than the asset being protected.
In other terms an investment made to reduce the risk of adverse price movements in a security, by taking an offsetting position in a related security, such as an option or a short sale.
Let's assume part of your investment portfolio includes 100
shares of Company XYZ, which manufactures autos. Because the auto industry is
cyclical (meaning Company XYZ usually sells more cars and is more profitable
during economic booms and sells fewer cars and is less profitable during
economic slumps), Company XYZ shares will probably be worth less if the economy
starts to deteriorate. How do you protect your investment?
Let’s understand with the below example:-
One way is to buy defensive stocks. These stocks might be
from the food, utility, or other industries that sell products The definition
of hedge on Investing Answers that consumers consider necessities. During
economic slumps, these stocks tend to gain or at least hold their value. Thus,
these stocks may gain when your XYZ shares lose.
Another way to hedge is to purchase a put option contract on
the shares (this would essentially allow you to "lock in" a
particular sale price on XYZ, so even if the stock crashed, you wouldn't suffer
much). You could also sell a futures contract, promising to sell your stock at
a set price at a certain point in the future.
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