Hedging is a method that aims to limit losses by purchasing investments that offer an opposite position to an existing investment in your portfolio. Hedges can often be placed using lower-cost options, futures or other derivatives. A perfect hedge, while rarely attainable, would eliminate all risk of a particular asset by being 100% inversely correlated to its price movements.

Accredited investors – typically high-net-worth investors – may also be able to access more sophisticated strategies in the form of hedge funds. These professionally managed investment vehicles employ complex strategies designed to reduce risk and yield absolute returns that are not tied to any particular benchmark. Although hedge funds can offer investors a way to improve the level of diversification – and at times produce strong returns across market cycles – they can come with barriers to entry, high fees and a relative lack of transparency.

Investing is inherently risky, but a hedging strategy could help to mitigate some of this risk. One way to do this is by investing in assets that are inversely correlated, meaning they tend to have the opposite reaction to the same market conditions. That way, if market forces cause one asset to decrease in value, the opposing strategy is likely to become more valuable and offset some losses. Less risk, of course, can mean less reward and the hedges that minimize a loss can also limit potential gains.

There are several reasons why you might want to hedge your risk. For starters, a hedging strategy could help you offset some of the risk of assets you consider risky to own on their own. A hedging strategy could also help to minimize the losses suffered if the market doesn’t perform as expected or help protect gains on an investment you already hold in your portfolio. Rather than selling the investment outright, an investor might consider adding a hedge to limit any potential losses while allowing them to hold on to the position and capture any additional upside.  

Financial hedging involves employing financial instruments to counter some of the risk that accompanies fluctuating interest rates, exchange rates or other factors that can affect a company’s bottom line. A coffee producer, for example, might engage in hedging to protect themselves against future increases in the price of coffee beans, a vital component of their cost of doing business.

Operational hedging is something businesses will do to mitigate risk to their operations. This could involve diversifying suppliers, using flexible manufacturing processes or locating production facilities in different geographic regions. Although this approach doesn’t directly tie into investing, understanding this form of hedging can help you assess how a business is being run and the steps it’s taking to reduce the impact of operational uncertainties on its performance.

Natural hedging involves investing in assets that are inherently negatively correlated, such as stocks versus bonds, since they typically move in opposite directions depending on interest rates. Companies can use natural hedges to guard against fluctuating exchange rates. For example, a Canadian business that sells its products south of the border could be at risk of losing some revenue if the exchange rate on the U.S. dollar weakens. A natural hedge to this risk would be to increase sales in Canada or move some production to the U.S.

Cross hedging is a strategy companies use to guard against market forces, often in instances where there are no futures available for an asset of interest. For example, a technology manufacturer might cross hedge its exposure to rare earth minerals by investing in companies that help mine the commodity or by investing in other assets that correlate positively to the minerals. Ideally, the company will look for an asset that tends to see its price rise and fall in unison with the asset the business needs to operate.

Tactical hedging generally refers to financial moves made to address short-term market variables. Strategic hedging, on the other hand, usually means employing standard, long-term strategies.

If an investor is worried that a particular asset in their portfolio is at risk of decreasing in value, they may want to guard against potential losses. A common way to do this is through the use of derivatives like futures contracts, options contracts and swaps. To decrease the risk of that asset of concern, an investor might consider purchasing a derivative contract known as a “put option” on its shares. Because a put option increases in value when a stock drops below a set price, the derivative essentially offsets some of the risk – and potential losses – of the underlying asset.

Spread hedging is an options trading strategy that involves identifying related assets or positions that, historically, tend to respond to market changes in a similar way, such as two securities that operate within the same sector. By taking opposing long and short positions in the two assets, an investor is hedging against the spread because an increase in value to one position will, ideally, offset any potential losses in the other. While relatively simple in theory, spread hedging can be complicated in practice and typically requires a deep understanding of market dynamics.

Hedging and diversification are two risk-reduction strategies that are often used interchangeably, though they are not the same thing. Hedging involves taking an offsetting position in an attempt to reduce the impact market volatility might have on a single asset. Hedging decreases the risk of an investment, but because of its structure and added cost can also decrease its potential upside. 

Diversification, on the other hand, is a way to insulate an entire portfolio by ensuring it contains an appropriate mix of different assets.

• It can help mitigate some risk: Well-placed hedges can reduce some of the risk that comes with investing.
• It can help you protect your gains: By purchasing an offsetting investment to one that has performed well, you can protect some of the gains you have already made, and potentially hold on to an investment longer if you feel it may still offer some upside.
• It can insulate against down markets: Because hedging could minimize losses, you may not feel as sharp a sting during periods of high market volatility.
• It could save time: A few good hedges can allow you to feel comfortable enough to decrease the amount of time you spend monitoring the markets.

• It can eat away at gains: Although hedging can help limit losses, the cost of purchasing offsetting assets can take a bite out of potential gains.
• It can be complex: Hedging strategies can be intimidating for newcomers to investing.
• It may prove unnecessary: If markets keep rising, the time and money you put into hedging could be viewed as unnecessary.