The definition of financial hedging is to buy insurance to limit the risk of the downside if an asset falls in value.
Hedging is a multi-position strategy that purchases insurance for an investment or trade position that is being held as a way to limit the downside losses if it trends against the investor. It is considered an advanced market strategy and was the original purpose of hedge funds to cap the downside risk during downtrends and volatility.
A simple everyday example of a hedge is to buy insurance on your home as it is a hedge against losing your house in a disaster. An example in investing is buying put option contracts on the SPY exchange traded fund if you own a large amount of SPY in your investment portfolio. Another example of a hedge is buying a long farther out-of-the-money option contract in a credit spread option play as a hedge against a short option contract sold closer-to-the-money. A hedge in an option play quantifies and limits the risk of the short position going against you.
A hedge is spending a small amount of money to lower, quantify, and limit your overall downside risk of a position moving against you. The cost of a hedge will lower the performance of what your investment would have done with no hedge but the cost is suppose to be worth it during a time when you would have taken a big drop in the value of the asset during a market crash or bear market.
To ‘Hedge your bets.’ means placing bets on a possible different outcomes from your original bet on an asset to either create a guaranteed profit on one side of your bet regardless of the final directional outcome of the market, or it means to at least reduce the amount of your risk on the market direction going against you.
A hedge is a tool for risk management, it is the cost of portfolio and position insurance. Its purpose is to keep losses small or at least quantified, and can create out performance at times over others that have no hedges on and also cause under performance in times where it is not needed with the drag of the extra expense.
