A hedge is an investment to offset the risk (in an investment) of market volatility, a bad trade, or a period of economic downturn. A hedge is analogous and can be thought of as insurance to protect an investor’s investment and downside.
The most common example of a hedge in investing is the use of derivatives, which include options, swaps and futures. For example, if Tom buys 100 shares of Random Inc (RAND) at $10 per share, he might choose to hedge his investment by purchasing a $5 put option with a strike price of $8 with an expiry period of one year. This option gives Tom the right and option to sell his 100 shares of RAND at $8 per share any time in the next year before the option expires.
One year later, if RAND is trading at $2, Tom won’t need to worry about his unrealised losses and can exercise his option and sell his 100 RAND shares at $8 per share, for a loss of $200 (excluding the price of the put option). On the other hand, if the share price of RAND increases to $20 per share, Tom won’t exercise his option (and let it expire) and cash in at a profit of $1, 000.
Hopefully, the example above helps you to understand the importance of hedging your downside (regardless of your confidence in an investment) and the need to be prepared in the case of an unforeseen event.