Hedging is a practice which separates professional options traders from amateur options traders. Hedging is the practice which allows so many professional options traders to both survive and profit heavily from options and stock trading over the span of several decades. So at this point you are probably wondering what hedging means exactly, especially if you are an amateur options trader who is looking for an edge over other options traders in the market. Is hedging limited to Market Makers and other professionals, or can amateurs participate as well?

 

Hedging is derived from the term 'to hedge', and describes a technique which was designed in order to either reduce or eliminate financial risk from one's portfolio. Hedging involves various calculated methods of employing insurance and protections onto a personal portfolio as a way to offset moves that work against the favor of the trader. But hedging is not actually restricted only to financial risks, as it is a practice which can be found in all aspects of our lives. For example, buying insurance is meant to hedge against the risks of unexpected medical injuries and expenses, and fire extinguishers and smoke detectors are purchased in order to hedge against fire risk. So in layman's terms, hedging is the act of offsetting risks using various means and methods.

 

Hedging, when used in financial terms, is defined as entering any transaction which will be used to protect your portfolio against a loss facilitated by a compensatory price movement. Are you wondering how hedging is performed by traders? In the simplest form of hedging, buying a stock which is going to rise as much as your stock portfolio has fallen is a good way to hedge. So if you are holding certain stocks and they are already profiting, but you want to safeguard that profit in case the stock falls, you would buy another stock which will raise by $1 for every $1 that the other stocks fall. That way, the second stock will rise every time the first stock falls; offsetting any loss that you would normally accumulate.

 

In reality, it is actually near impossible for anyone to find a stock which will move perfectly opposite to a stock in your portfolio in order to create a hedging trade. This is actually why stock options and other derivatives are created. Stock options as hedging tools are most classically used in a Married Put strategy, which involves buying a contract of Put options for every set of 100 owned shares. In this example, the put option will raise by $1 for every single $1 drop that occurs in the underlying stock, which hedges the loss in your shares. Even new and amateur traders can use this method in order to begin hedging their own stock portfolio against potential losses. If you are an amateur trader, you should stick to this form of hedging. If you have a larger portfolio and more experience with options trading, there are other forms of hedging which may be worth exploring.