Hedging is a trading strategy where traders use financial instruments or strategies to reduce the risks associated with an investment position. Traders hedge to limit potential losses resulting from unexpected price movements in a particular asset. Hedging can be done in various financial markets, ranging from stocks and currencies to commodities and stock indices.
When a trader has an open position in an asset, they can take an offsetting position in another asset that is negatively correlated to the original position. This can be done by purchasing a derivative product, such as a stock option or a stock index future. This way, if the particular share price declines, the option or futures contract would increase in value, offsetting the losses in the original position.
An investor who has a stock position open foresees that the stock price will experience momentary dips. They do not want to exit their position, so they decide to hedge against these potential losses by buying put options on the stocks. If the stock price does fall, the trader’s put options will increase in value. This can offset some of the losses the trader incurs in their initial position.
Traders who want to use hedging as part of their trading strategy should make sure they understand the relationship between the hedge and their existing open positions. They may also incur additional costs when hedging, such as transaction fees and margin requirements. This can take away from their potential gains from the hedge, and therefore should be considered carefully.
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