What it is:
How it works (Example):
Portfolio hedging typically entails the use of financial derivatives (options and futures) to curtail losses. For example, an investor worried about short-term price swings in ABC stock can hedge their stock portfolio against short-term losses by purchasing the same number of ABC put options. A decline in the value of ABC shares will be hedged, or offset, by profits from the put options.
There are a wide assortment of options and futures contracts that an investor can hedge against nearly every type of risk. For example, hedges can be created to protect a portfolio from stock and commodity price movements, interest rate changes and currency swings.
Why it Matters:
The purpose of portfolio hedging is to curtail potential losses. This safety also comes at a price, since hedging also limits potential profits. Every hedge has a cost, so investors should weigh the costs of the hedge against its benefits. For most buy-and-hold investors, hedging is unnecessary, since short-term price swings in a portfolio won’t matter.