Definition of Hedging

Definition of Hedging. What is Hedging and why is it so important that you understand how to use hedging to protect yourself.

What is Hedging

What is hedging? Hedging is defined as a strategy which reduces or eliminates risks while locking in profits. Investors buy and sell specific investments in order to reduce the risk associated with the portfolio of investments. Hedging strategies thus seek to reduce, if not eliminate risk.

In everyday terms, hedging is a way to gain protection against a potentially adverse outcome. In gambling, this might involve placing an additional bet in order to reduce the risk of another outstanding risk.

Ways to Hedge Investments

When hedging investments, investors will take an offsetting position in a related security, perhaps through options or short positions.

Alternatively, especially in the commodities markets, investors might take a buy or sell position in a futures market that opposes the position in the cash market to minimize the risk of financial loss. Producers and manufacturers can also protect the prices of their raw commodities this way.

Difference between Hedging and Arbitrage

Unlike arbitrage, hedging does not necessarily involve mispriced assets. The main difference between hedging and arbitrage is that arbitrage focuses on profits while hedging focuses on lowering risks.

Examples of Hedging

For examples of how to make money with hedging and protect your investments from possible downsides, see Hedging with Options and Hedging Strategy.

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