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A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.
Hedging is analogous to taking out an insurance policy. If you own a home in a flood-prone area, you will want to protect that asset from the risk of flooding – to hedge it, in other words – by taking out flood insurance. There is a risk-reward tradeoff inherent in hedging; while it reduces potential risk, it also chips away at potential gains. Put simply, hedging isn't free. In the case of the flood insurance policy, the monthly payments add up, and if the flood never comes, the policy holder receives no payout. Still, most people would choose to take that predictable, circumscribed loss rather than suddenly lose the roof over their head.
A perfect hedge is one that eliminates all risk in a position or portfolio. In other words, the hedge is 100% inversely correlated to the vulnerable asset. This is more an ideal than a reality on the ground, and even the hypothetical perfect hedge is not without cost. Basis risk refers to the risk that an asset and a hedge will not move in opposite directions as expected; «basis» refers to the discrepancy.
Derivatives are securities that move in terms of one or more underlying assets; they include options, swaps, futures and forward contracts. The underlying assets can be stocks, bonds, commodities, currencies, indices or interest rates. Derivatives can be effective hedges against their underlying assets, since the relationship between the two is more or less clearly defined.
For example, if Morty buys 100 shares of Stock plc (STOCK) at $10 per share, he might hedge his investment by taking out a $5 American put option with a strike price of $8 expiring in one year. This option gives Morty the right to sell 100 shares of STOCK for $8 any time in the next year. If a year later STOCK is trading at $12, Morty will not exercise the option and will be out $5; he's unlikely to fret, however, since his unrealized gain is $200 ($195 including the price of the put). If STOCK is trading at $0, on the other hand, Morty will exercise the option and sell his shares for $8, for a loss of $200 ($205). Without the option, he stood to lose his entire investment.
The effectiveness of a derivative hedge is expressed in terms of delta, sometimes called the «hedge ratio.» Delta is the amount the price of a derivative moves per $1.00 movement in the price of the underlying asset.
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