What is hedging?

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What is hedging?

Hedging is an advanced risk management strategy that involves buying or selling an investment to potentially help reduce the risk of loss of an existing position. Hedging is not a commonly used trading strategy among individual investors, and in the cases where it is used, it is typically implemented at some point after an initial investment is made. That is, you are not hedging a position at the beginning of buying or shorting a stock.

Let's look at a hypothetical hedging example. Let's say you bought 100 shares of XYZ stock at $30 per share in January. Several months later, the stock is trading at $25. Assume that you don't want to sell the stock (perhaps because you still think it can increase over time and you don't want to enter into a taxable event), but you want to reduce your exposure to further losses. To hedge this position, you can consider a protective put strategy—buying put options on a share-for-share basis on the same stock. Puts give the right, but not the obligation, to sell the stock at a particular price, within a specified time period. Let's say you bought enough put options to hedge your existing position with a strike price of $20. In this scenario, you will be protected from additional losses under $20 (for the duration of the time you own the put option). You can learn more about trading options here.