Identification

Hedging is when you make an investment to reduce the risk of declining prices in an underlying asset. Investors use this strategy when they are unsure of market conditions. The ideal hedge would reduce the risk to nothing but the cost of the hedge. For example, if the dollar falls, U.S. companies may struggle and investors tend to hedge their portfolios with gold. This is because when the dollar loses value, gold's value increases, thus driving the price of gold upward. Investors hope that the profit from investing in gold offsets any loss in other assets.

Protective Puts

A put option gives the holder of a stock the right to sell an underlying asset to the writer of a contract at a specific price or "strike price." Protective puts are put options that are purchased for stock already owned. A protective put helps protect an asset from a drop in price. If the stock drops, then the put offsets the loss. This can be done by buying puts "at the money," which is when the strike price and prevailing stock price is the same. If you own Apple stock and wanted to limit a possible decline you would buy protective puts in Apple. The buyer of your protective puts hopes that the stock goes up in order to resell at a higher price. However, if Apple declines you would receive a premium from the contract, which may offset the original decline in Apple.

Covered Calls

A call option gives the holder of the contract the right to buy the underlying security at a specific price or "strike price" for a fixed period of time. A call option is the opposite of a put. A put is used when you think the stock will go down, while a call is used when you think the stock will go up. This is because you have the right to buy the underlying stock from someone else at a fixed price. If the price goes up, you can sell that stock for current market value, or sell the contract at a higher price. A covered call hedges against a small decline in price by selling call options. For example, say you own 400 shares of Microsoft and believe it will drop a bit or stay stagnant. You would write four contracts for a fixed rate and time. It would look like this--Jun25Call. This indicates that it is a call that will expire in June, and the strike price is $25. If at the expiration date Microsoft is $25.50 you would receive a $.50 premium per share including the value of the four original contracts. That would equate to a $200 profit.

Neutral Hedge

A neutral hedge is done by combining positions in various investments in hopes of creating a risk-free portfolio. For example, a portfolio that includes health care stocks may do well during a market downturn. This is because health care is a necessity and holds well during rough economical times. On the other hand, consumer discretionary (clothes, entertainment, etc) stocks do well during positive market conditions. If there is economical stress consumer discretionary stocks will tend to drop, but health care can hedge the potential loss. However, when the economical situation is reversed, discretionary stock will go up. Health care stocks may not decline during this period. It can act as a safety net.

Potential

By learning how to hedge you can protect your portfolio from possible declines. This can become very useful in a high volatility market. Hedging is not limited to professional traders. It is limited to those who know how.

Warning

Please consult your financial adviser or planner before investing. Be aware of your individual risk tolerance and financial objective. All investments carry risk and a potential for loss. Although, hedging is a beneficial tool, it may not fully protect you from loss.

Source:

Hedge Explained

Options Hedge

Neutral Hedge