In its simplest form, hedging means taking both
long
and
short positions.
In the case of stock, a long position means you buy shares and hold them in your portfolio because you expect them to provide a strong return. A short position means you borrow shares and sell them, expecting the price to drop so that you can repurchase at a lower price, return the shares, and make a profit. In fact, when the term hedge fund was first coined in the late 1940s, it described an investment fund that took both long and short positions in a number of stocks in order to produce positive returns in all market conditions.
A hedge fund might buy stocks in companies its research suggests are undervalued and sell short stocks that are overvalued. If the market is active and prices are going up, the fund expects to profit on the stocks it bought and lose money on the stocks it sold short. If the market falters, it may lose money on its long positions and profit on the short sales. The goal is to earn at least marginally more on the upside than it loses on the downside.
Risk protection at a price
As an investor, you hedge to reduce or neutralize market risk. Although you’re protected to some extent from losses, hedges are rarely perfect. Further, some of your potential profit will be offset by what you lose on the other side of the transaction. But you may realize gain with less risk or lose less than you might have done if you had committed your principal in only one way.
