Definition of Hedging – Setting up an investment positions which helps to protect against losses from a related investment.
For example, if you export goods to the US, an appreciation in the exchange rate can make your exports uncompetitive. Therefore, you can hedge against your position by buying Sterling futures. If sterling appreciates, your exports become uncompetitive, but you benefit from the rise in the value of Sterling.
When weighing up what to buy and where to invest some speculators may wish to hedge against risky investment.
A simple way to engage in hedging is to buy a safe asset for every risky asset. However, some people may want to hedge against a particular investment. This can be done by using derivatives.
Hedging with Put Options
An example is using a put option. This gives the owner the right, but not the obligation, to sell at a certain fixed price, before a certain date.
This means that if the share price falls more than the agreed price (striking price) then you can sell it.
Example, suppose you buy shares in ICI for 100p, hoping they will increase in value. To hedge, you could also take out a put option, which gives you the right to sell shares in ICI for 80p in the next 6 months. This means that if shares in ICI fall by 30%, the investor can sell at 80p.