In the stock market, taking risks is a common thing. However, just as important is investing in risk reduction. Thus, this is where hedge stocks and the concept of hedging comes in.
What is a hedge stock?
A hedge stock refers to an investment against something negative. Hedging is when someone tries to protect from unwanted financial situations. In various cases, a hedge stock is insurance against a probable but unfortunate event like car insurance. To sum it up, hedging is an attempt to avoid losses or risks to one’s finances.
Hedge stocks come in handy in the case of major catastrophes like a stock market crash or inflation. For example, many use gold as a hedge against inflation of the dollar since it never changes in value.
However, hedging isn’t as simple as things like house insurance. Rather, for every hedge stock, there is an equal and opposite stock, the risk against which the hedge protects. Consequently, the potential profit of the stock lessens alongside the amount of risk hedging alleviates. Hedging may involve trading another stock tactically.
Since hedging is an investment, it means it will have associated expenses. A hedge stock is just like any other stock. Nothing is certain, just like the ever-changing stock market.
One such hedging strategy utilizes derivatives. With asset-based value, derivatives are contracts that businesses use for purchase agreements. For example, one might trade a derivative contract to buy an asset on a certain date with an agreed price. Mainly used for high-value commodities like oil, it makes sense how derivatives aim to reduce risk. So if a commodity’s price increases, the derivative ensures the original, agreed-upon price. As a result, derivatives offset the volatile nature of the stock market.
Another way to hedge is portfolio diversification. When you have a variable mixture of assets, like stocks, bonds, and other cash equivalents or investments, they can react differently in any event. In other words, a certain event causes one asset to drop while another to rise. Otherwise, if all stocks are similar, most of them will react negatively at the same time, which is the ultimate risk.
Hedging is a huge field, with countless types and strategies. Whether you decide to hedge or not, a strong understanding of them allows for better stock market analysis.