What Is Hedging?

Hedging refers to buying an investment designed to reduce the risk of losses from another investment. Investors will often buy an opposite investment to do this, such as by using a put option to hedge against losses in a stock position, since a loss in the stock will be somewhat offset by a gain in the option.

How hedging works

There are several ways to hedge your investments, and one common method is with derivatives or futures contracts. For example, if you own shares of a stock, you could buy an out-of-the-money put option to protect yourself in the event that the stock's price declines dramatically. A broader example of this would be shorting a stock index through futures in order to protect your entire portfolio from the effects of a market correction.

Or, if you want to invest in one company to protect yourself from industry weakness, you can buy that company's stock while simultaneously shorting one of its weaker competitors. The point is that there are lots of potential ways you can hedge your investments, as long as one asset can be reasonably expected to go up in value when the other goes down.

In practice, hedging doesn't usually eliminate risk altogether (known as a "perfect hedge"). Rather, it is used to lessen the impact of an otherwise devastating event. Think of hedging like buying car insurance -- sure, you'll still have to pay a deductible if you need to use it and you may be without your car for a little while, but it's a better outcome than not having it at all. The insurance premiums are the cost of reducing the risk, and if you don't use your insurance, that money is gone.

An example of a hedge

Let's say that you buy 500 shares of Citigroup because you think the banking sector is going to perform well over the next few years. As of this writing, Citigroup trades for about $44.50, so this investment would cost $22,250.

Let's say that you feel that this investment is a little risky right now given what's going on in Europe, so you decide to hedge your position by purchasing five put option contracts that allow you to sell your shares for $40 at any time before Jan. 2017. The options premium you pay is $180 per contract, so five contracts would cost $900.

Now, if Citigroup fell to $30 per share by the end of 2016, your initial investment would be worth $15,000, for a loss of $7,250. However, your put options would have an intrinsic value of $5,000 in this scenario. Subtracting the $900 you paid for the contracts would result in a profit of $4,100.

So, your hedge would have resulted in an overall loss of $3,150 -- still significant, but much better than the $7,250 you would have lost if you didn't hedge.

The bottom line

Not all investments need to be hedged -- if you're confident about your stocks over the long run, there's generally no need to spend money on hedging instruments. On the other hand, if one of your stocks has shot up higher than you thought it would or you make a trade in the hopes of a short-term profit, hedging strategies may be a good idea for you in order to limit your downside risk.

This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at knowledgecenter@fool.com . Thanks -- and Fool on!