What is a simple example of hedging?

For example, if you buy homeowners insurance, you're protecting yourself against fire, theft, or other unforeseen disasters. Portfolio managers, individual investors, and companies use hedging techniques to reduce their exposure to various risks. Hedging is a strategy that seeks to limit the risks of financial assets. Use financial instruments or market strategies to offset the risk of any adverse price movement.

In other words, investors hedge an investment by making a trade in another. The best way to think about coverage is a form of insurance against unforeseen circumstances that can have financial ramifications. In the event of an unforeseen circumstance, a properly hedged position reduces the possible losses that could have occurred. An example from everyday life is car insurance, which protects the driver against theft and accidents, among other risks.

The formalization of hedging as a financial practice gained momentum with the creation of the Chicago Board of Commerce (CBOT) in 1848, which introduced standardized futures contracts. These contracts allowed market participants to set the price of a commodity in advance, which mitigated the risks associated with price volatility. For example, when using options contracts as hedging, traders must pay a premium for the option, which may vary depending on factors such as market conditions and expiration time. Likewise, when using futures contracts, there may be fees associated with brokerage.