"Hedging Helps Prevent You From Losing Money"
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What is Hedging
In investing, hedging is used in much the same way as what we mean when we refer to: "hedge your bets."
In common terms it refers to someone making a bet but somehow arranging the terms so they'll win even if they lose.
That's pretty much what investment hedging means in the financial world
It's a way of making investments that run against each other, so that no matter which one does better, you still make money.
As I write, the 2006 mid-term elections are only about two weeks away.
Now, we all know that in many businesses or career field it helps to have politicians in office feel friendly and indebted to you.
And how to you make politicians feel friendly and indebted to your business or your career?
As we all know, politicians like money (as do we all).
Now, it's illegal to give a politician a large amount of money -- directly. You can't just write Senator So-and-So a check for $1,000,000.
However, it is legal to contribute to the politician's campaign fund, up to certain limits.
The politician cannot (legally) buy a new car with your money, but he or she can buy some TV ads and to politicians that's better than a new car.
Let's say that you are a lifelong Democrat and you fervently hope the Democratic candidate for the House of Representatives in your district wins.
So you contribute as much money as you can to their campaign fund. Because you believe in them and their party.
Now, that's making an unhedged investment in that candidate's 2006 campaign.
If they win, you feel good. And if you gave a large enough contribution, you can call Representative up one day and find a sympathetic ear when you tell them what kind of new law your business needs.
If the Democratic candidate loses, the Republican in office owes you squat.
But let's say your goal is not the promotion of one party or the other, but the promotion of your business goals through political action
Therefore, and this is not uncommon in the real world, you make a sizable contribution to the campaign funds of BOTH candidates.
That's hedging your political contributions.
You don't care which one wins -- because both have accepted your contributions and will listen when you call about how some pending legislation would affect your business.
If the Republican wins, in a very narrow sense the money you contributed to the Democratic candidate was "wasted." Because you will get no direct return on it, because they lost. They're not in office, so they can't help you.
However, you had to make the contributions during the election, when you could not predict the final result, and so you look upon the total of both contributions as an investment in your business's future.
You hedged your bets
No matter which candidate wins, you win your real goal, which was to have some political influence.
In investing, hedging strategies is not putting all your money in any one investment. Because if that investment goes down, all your money goes down.
It's much safer to spread it around.
You can't always invest in such obvious opponents as the Democratic and Republican candidates in an election, but you can still spread your money around to reduce risk.
Hedging sometimes refers to how you structure individual trades so that you limit how much money you make, but at the same time you limit how much you can lose. This is particularly true of options and commodities.
Hedge funds are called that not because they always hedge their investments (far from it), but because they are legally allowed to go short as well as long. Mutual funds can buy shares of stock in a certain company, for example, but cannot also sell them short or buy puts to protect the value of their investment portfolio. Hedge funds can.
But that doesn't mean they do. Hedge fund managers seem to be as vulnerable as other human beings to the arrogance of believing their view of the markets is correct and inevitable and therefore their position to benefit from that view is the only logical one, and therefore there is no reason to hedge their position.
Using financial techniques such as options to hedge your trades is similar to what bookies do.
Bookies do not want to bet on the outcome of any given game or other sports event. It's a business to them. They don't want their income dependent on which team wins.
Therefore, when their customers bet more on one team than the other (a common situation, and it's especially prevalent for the city's own sports franchises), bookies hedge their positions by laying off with other bookies. That means they make arrangements with other bookies to back each other up no matter what happens in the game.
Smart bookies make their money from the premium they charge their customers to make the bets. They don't want to have to worry about one team beating the other.
Smart bookies don't look to get rich from betting on one team or another. They look to make a steady stream of profits from covering the bets of gamblers who think they know the game's outcome.
Smart investors do the same thing. They don't risk all their money on one company or one type of investment or one deal or one trade. They want to make a steady stream of profits no matter whether the stock market is up or down, bonds or up or down, and so on.
Next, a particular form of hedging is to put your money in a variety of investments, which is called: Diversification
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