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In finance, a hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment. The term is a shortened form of " hedging your bets", a gambling term. Typical hedgers purchase a security that the investor thinks will increase in value, and combine this with a "short sell" of a related security or securities in case the market as a whole goes down in value.
The practice can be illustrated with an example. An investor believes that the company FOO is going to do well this month, and wishes to buy some shares of stock so as to profit from their rise in value. FOO is, however, part of the widgets industry, a sector whose share prices are highly volatile.
Our investor is interested in the company itself, not the vagaries of the industry, and so seeks to hedge out the risk by selling short an equal amount of the shares of FOO's direct competitor, BAR.
On day one, our investor's portfolio looks like this:
(Notice that the investor has sold short the same value of shares, not the same number; this is important).
On day two, there is a big news story about the widgets industry and the value of all widgets stock goes up. FOO, however, because it is a stronger company, goes up by 10%, while BAR goes up by just 5%:
(Remember that in a short position, the investor loses money when the price goes up)
Perhaps our investor is regretting the hedge on day two, because it has cut into the profits on the FOO position, but on day three there is another news story that is bad for widgets, and all widgets stock goes down.
This time it's a real crash — 50% is wiped off the value of the widgets industry in the course of a few hours. Once again, however, because FOO is the better company it suffers less than BAR:
Value of long position:
Value of short position:
Without the hedge, our investor would be looking at a loss of 450 USD. With the hedge, that loss still stands on the long side, but the short side is in profit of 495 USD. That means our investor in widgets is still 45 USD in profit on a day when the market suffered a dramatic collapse.
The example above is a "classic" sort of hedge, known in the industry as a "pairs trade" due to the trading on a pair of related securities. As investors became more sophisticated, along with the mathematical tools used to calculate values, known as models, the types of hedges has increased greatly. In general, however, all hedge strategies look for a "spread" between market value and real value, and attempt to extract profits when the values converge.
Another of the classic hedge strategies is to buy the stock of a company that is being taken over in a mergerThis page deals with the combination of two companies into one. For information about other uses of the word "merge", see merge. In business or economics a merger is a combination of two companies into one larger company. Such actions are commonly volunta, while shorting the stock of the company that is buying them. In this case the details of the merger are known in advance, for instance company A may offer 10 shares of their own stock for every 8 of company B, which they are purchasing. Given the current market values, the dollar amounts of the takeover bid can be calculated, and the spread between current value and the announced takeover value can be calculated. If the current stock price is below the takeover value, the deal is said to be "in the money".
The hedge in this case is to remove the risk that the takeover will fail. For instance if company B rejects the takeover bid, their stock price will typically fall to its original value, or lower. The same however is also true of company A, whose perceived value will drop as a result of failing in their venture. Therefore the hedging opportunity is to purchase shares of company B (if it is in the money), and short the shares of company A. This way some profit will be made in either case, with the spread disappearing and creating a profit on the long position, while in the case of the deal breaking down the losses on the long position will be hedged out by the gains on the short when the shares of company A fall.
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