What Is Hedging?

Hedging is the application of investment techniques to minimize risk in a portfolio. This can be done by professional money managers and by individual investors. There are many ways to hedge, but it basically is making a trade, bet or investment in an attempt to protect an investor from potential losses in another investment. In order to hedge successfully, the second investment must be in negative correlation to the original trade or investment. This means that one investment is producing returns that exceed those of the broader financial markets, and the other investment, which is the trade placed to hedge, generally generates returns that are below the markets.

Investors use hedging in a portfolio to provide a level of insurance against potential losses and against unexpected and unwanted price movements in securities. Sophisticated trading strategies and instruments, such as derivatives that include options securities, are designed to provide this layer of protection. Options are financial instruments that, for a price, give investors the right to buy or sell a security at a given price before the expiration date. These financial securities can be applied to a host of different asset classes, including stocks, bonds and commodities, among others.

Hedge funds are loosely regulated, private investment portfolios containing the investments of both institutional investors and wealthy individuals. They are run by professional fund managers. Hedge fund managers earn layers of fees from investors large and small for successfully using hedging strategies. A typical ratio for a hedge fund manager to earn is a 2 percent management fee and a 20 percent performance fee, as long as returns don't falter. If a hedge fund is not making investors money — these investment vehicles are designed to produce profits that are above the broader financial markets — then the performance fee can be waived.

The manager of a hedge fund applies hedging techniques to a number of investment strategies. Long/short equity is among the most common of those trading styles. In this hedging strategy, the fund manager bets that a security will rise in value by "going long" or buying shares. On the other end of that trade, the hedging takes place with another bet that a different security will decline in value, a bet known as shorting. Sometimes the hedge fund manager is so sure that a stock will fall that he or he adds debt to the trade by borrowing money from a broker, but if the manager bets wrong, that money still must be repaid.