A definition of hedging is when you use an option to “hedge” your bets, or as I prefer to call it, betting the market against itself. What I mean by hedging is that when a person is trading a security, and they do not have an option to trade the security at that particular point in time, they are hedging their bet, and thus their risk level.
To make the definition easier to understand, let’s go over the definition of hedging. If someone wants to protect their money by hedging their bets, what they are doing is placing the risk of losing all their money against their winning money. For example, a hedge fund manager hedges his or her position of buying currency and selling currency by purchasing some of the currencies that the market is currently trading and then holding that position of buying for a certain period of time until the market reverses.
Of course, hedging is not limited to just buying and holding currencies. A hedge fund manager can also hedge their position of buying and holding a currency against another currency, as in a situation where the market is suddenly going up in one direction, but has been going down the other direction for a long time.
In order for hedging to be successful, it requires two things. The first is the ability to predict which way a market will move, and the second is that the trader has the patience to wait for the market to correct themselves and return back to the position that they had initially taken. For example, if you have an option on a stock that is going to go up fifty points in a day, and the market was moving in a direction that could only give you a gain of forty points in that same day, you would need to be able to cover that gain in a day by holding that option, and not selling the stock immediately.
So how does hedging work? The answer, in short, is that in the real world you are betting against the market itself. If you have an option that gives you the right to buy or sell a certain amount of stock at a specific price, but that price goes up for no reason, you are taking that option and making it your own bet, and not just holding it until it goes back down. This makes hedging your bets a form of insurance, that is, a sort of “if you buy, you win”.
When you hedge your options, what you are basically doing is using that insurance to protect your investment. It should be noted, however, that you should never completely rely on a hedging strategy as a “get rich quick” scheme. If you hedge your options, you will still lose money.