What’s the purpose of hedging a stock or your portfolio?
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What’s the purpose of hedging a stock or hedging your portfolio?
First, let’s take a look at what hedging really means. In the stock market, when you hedge a stock, what you are doing is limiting or reducing your risk. Because as you know, investing in the stock market is all about managing your risks and the trades and investments you have on hand.
The way you hedge one investment is by making another investment that goes against that primary one. Hedging is not a technique you use to make money, but rather to reduce a potential loss.
When you hedge a stock, you are insuring that stock against a negative event by making a secondary investment. Meaning, in case your primary investment goes against you and loses money, when you are properly hedged, the negative impact will be reduced and you won’t lose as much money.
For example, if you have a big amount of money invested in one stock, let’s call it XYZ. You can hedge that stock, and in case your XYZ position goes lower, at least your hedging position goes higher and it compensates you for that difference. Ultimately that’s the goal, so you don’t lose as much money from your primary investment.
The downside of hedging is that, of course, every time you put on a hedge, it’s going to cost you time, money, energy and resources. Also, if your primary investment is actually going in your favor, and the stock continues to move higher, then this hedge ultimately is going to continue to lose value and it will reduce the profit that you could’ve made in the first place.
You have to be careful because if you over-hedge, it can actually work against you. Your goal is to hedge enough to where you are protected, but not too much to where it can actually cause you even more problems.
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