If someone wrote the word “hedging” on a paper and slapped it down in front of you, what would your immediate thought on the word be? Trimming the bushes is a likely first response, or maybe something similar to topiary. Obviously, you're not very familiar with the Forex market. This is actually a trading term– unexpected, right? Hedging can be incredibly helpful if you're about to enter the world of trading the forex market. Hedging in the market can be easily thought of as hedging a bush though, so you weren't entirely off base. It's trimming back on the risks, but building a wall of protection instead of cutting leaves from your money tree.
What is it?
The easiest way to explain hedging to the average person is to compare it to insurance, because when you're risking something, you want insurance backing you up to feel secure in case the worst happens. It's important to remember that just like an insurance representative won't stand in front of you and take a bullet for you, hedging doesn't entirely eliminate the risk. While that rep won't protect you from a bullet, he'll help you pay your medical bills once you get out of the hospital. It's like that. You've still lost, but not as much as you could have if you were stuck with all those bills to take care of, plus a bunch of aches and pains. If you properly hedge before investing, you'll cut the medical bills, but keep the aches and pains.
The best thing about learning to hedge is that anybody can do it. You don't need a degree from Harvard to learn how to invest properly, and you certainly don't need to be a rocket scientist to know you need to be careful when doing it. There are several different hedging techniques, all of which vary in degrees of knowledge of the market. But the most basic form of hedging is to place your money into two entire different things, like instead of investing in Smucker's Jam and Jif Peanut Butter, go with the Jam but put in a motor oil too. This is still going to cost you money, don't think of it as a way to make money and save money. Remember, like an insurance plan, you're not saving money by paying it every month. But the good news is, if nobody wants peanut butter and jelly sandwiches this summer, you only lose a portion of your investment into the jam, but not in the motor oil. This is basic hedging. More complex hedging is done via derivatives, which is something only the most seasoned of investors go after.
Is There a Downside to Hedging?
As with all market investments and strategies, don't expect easy choices and easy money. Everything comes at a cost, and hedging is no different. Before just investing in two random companies, do your research. Follow market trends, and if it's definitely a good year for peanut butter and jelly, then there's no need to invest in something else via hedging that will lose you money. This is counterproductive to the ultimate goal, which is of course to make money. You should also know, hedging is not intended to be a “get rich” scheme, and you will not make an enormous total sum by hedging in all of your trades. Remember this is intended as a bright side “well I didn't lose it all,” method to offer some comfort when an investment goes totally south.
It's also important to bring up that under all circumstances, your hedge will cost you money, and things don't always go just as planned in terms of protection.
Should I Hedge?
For something that sounds so wonderful, it may seem surprising that through the entire career of some investors, they never hedge once. Playing the market is a way to make money through the long-term, and hedging protects mainly from short-term fluctuations, which if you're learning the market, you'll find aren't as soul crushing as they seem to be. You could lose $400 one day, and gain $1400 the next, only to come out with a net profit of $1000. Hedging is a short-term insurance, so if that's not your style, that doesn't mean you should dismiss the concept entirely.
Hedging may not be for everybody, but it's always good to know about as many market strategies as you can before you play the game. As with any investment risk you make, always remember to check into it fully, as nobody wants to invest in a sour lemon and lose everything. While hedging can save you money, it also costs you money, and sometimes can end up costing you the same as what you lost, and you'll walk away with less profit than you started. Always make sure your investment choices are well-planned, and remember that you're playing a game of strategy and luck when you trade.
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