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Word lists shared by our community of dictionary fans. Sign up now or Log in. A classic example of hedging involves a wheat farmer and the wheat futures market. The farmer plants his seeds in the spring and sells his harvest in the fall. In the intervening months, the farmer is subject to the price risk that wheat will be lower in the fall than it is now.
While the farmer wants to make as much money as possible from his harvest, he does not want to speculate on the price of wheat. This is known as a forward hedge. Suppose that six months pass and the farmer is ready to harvest and sell his wheat at the prevailing market price. He sells his wheat for that price. The farmer has limited his losses, but also his gains. Risk is an essential, yet a precarious element of investing. Regardless of what kind of investor one aims to be, having a basic knowledge of hedging strategies will lead to better awareness of how investors and companies work to protect themselves.
Whether or not you decide to start practicing the intricate uses of derivatives, learning about how hedging works will help advance your understanding of the market, which will always help you be a better investor. Soft Commodities Trading. Your Privacy Rights. To change or withdraw your consent choices for Investopedia.
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Example of a Forward Hedge. The Bottom Line. Recent Examples on the Web: Noun When the company's share price rose dramatically, those hedge funds allegedly had to buy stock in the company to cover their positions, triggering even bigger gains.
Watson, WSJ , 21 Apr. First Known Use of hedge Noun before the 12th century, in the meaning defined at sense 1a Verb 14th century, in the meaning defined at transitive sense 1 Adjective 14th century, in the meaning defined at sense 1.
Learn More About hedge. Time Traveler for hedge The first known use of hedge was before the 12th century See more words from the same century.
Style: MLA. More Definitions for hedge. English Language Learners Definition of hedge Entry 1 of 2. Kids Definition of hedge Entry 1 of 2. Kids Definition of hedge Entry 2 of 2. Legal Definition of hedge. This strategy has its trade offs: If wages are high and jobs are plentiful, the luxury goods maker might thrive, but few investors would be attracted to boring counter-cyclical stocks, which might fall as capital flows to more exciting places.
It also has its risks: There is no guarantee that the luxury goods stock and the hedge will move in opposite directions. They could both drop due to one catastrophic event, as happened during the financial crisis, or for two unrelated reasons. In the index space, moderate price declines are quite common, and they are also highly unpredictable. Investors focusing in this area may be more concerned with moderate declines than with more severe ones.
In these cases, a bear put spread is a common hedging strategy. In this type of spread, the index investor buys a put which has a higher strike price. Next, she sells a put with a lower strike price but the same expiration date. Depending upon the way that the index behaves, the investor thus has a degree of price protection equal to the difference between the two strike prices minus the cost.
While this is likely to be a moderate amount of protection, it is often sufficient to cover a brief downturn in the index. First, as indicated above, hedging is imperfect and is not a guarantee of future success, nor does it ensure that any losses will be mitigated. Rather, investors should think of hedging in terms of pros and cons. Do the benefits of a particular strategy outweigh the added expense it requires?
For most investors, hedging will never come into play in their financial activities. Many investors are unlikely to trade a derivative contract at any point. Part of the reason for this is that investors with a long-term strategy, such as those individuals saving for retirement, tend to ignore the day-to-day fluctuations of a given security. In these cases, short-term fluctuations are not critical because an investment will likely grow with the overall market.
For investors who fall into the buy-and-hold category, there may seem to be little to no reason to learn about hedging at all.
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