Hedging

Hedging is basically a strategy that is used to cover losses or cut losses.

There are various ways to hedge, but I'll focus on Options. The reason why I chose to focus on Options is because I'm being tested on it plus with Options you can not only cut your losses, but you can also make money.

Basically options are contracts to either buy or sell. The purchaser of an option pays a premium to the person writing the option. They purchase a contract to buy something in the future (Call Option) or to sell something in the future (Put Option). The Option has an Exercise price (the price to buy / sell at) as well as an Expiration date.

If you have 1,000 shares of Company A worth $100 today, but you don't want to sell it until one year from now, you can buy a Put Option to hedge the shares so that even if the price goes down you can still sell at $100 per share.

How this works is you go to the market and buy a Put Option to sell 1,000 shares of Company A at $100. The Put Option will cost you a premium (let's say $1,000). After one year, if the share price of Company A falls to $80, you're covered because the Option that you purchased guarantees that whoever you bought the Option from will buy your shares for $100 per share. Instead of losing out on $20 per share ($20 x 1,000 = $20,000) you only lose what you paid for in the premium ($1,000).

If the price of Company A rises to $120 per share, you just let the Put Option expire (it doesn't make sense to go through with the contract and sell for $100 when you can sell it to the market for $120).

As a general rule if you want to hedge a Long Position asset you buy a Short Position option, and vice versa.