I’ve noticed recently as things in the world have gotten, shall we say, “a little more volatile,” that people are starting to throw the word “hedge” around. I’ve also noticed that not everyone may be aware of what they’re referring to. It’s actually pretty simple, so let me try to help.
Picture an old European garden. A traditional hedge serves as a divider, kind of like a fence, between two sections.
In finance, a hedge is a divider too – only instead of divvying up sections of a garden, it divides a bet into more than one component, typically with the intention to offset a risk. Those components could be a single game of cards versus a whole night of playing card games, or even a side-bet on a single hand in the context of a longer night (aka a “prop bet”). We’re going to set the concept of multiple bets aside for now (that’s called diversification) and just focus on the dividing hedge itself. If you’re already feeling lost, take a deep breath – it gets easier.
Like the garden-hedge determines the visual profile of the garden, the financial-hedge determines the risk AND reward profile of an account’s value. Think of the hedge as telling you how risk looks. It’s about perspective. If you stick with the garden / visual concept, you can probably start to intuitively make sense of some of the other financial hedging language like symmetrical, asymmetrical, skewed, etc. that you may hear.
While there are lots of different types of hedges, we can explore a few really basic examples using a coin flip.
If we were to bet $1 on a coin flip, we could say we “hedged our bet” by sizing our risk to be a max loss of $1. Presumably, if we can both sustain the loss of a dollar (we have more than just that dollar in our respective accounts), then we’ve separated our bet from our total bankroll by controlling the bet’s size. In most cases, position sizing is the easiest and least expensive hedge. Want less risk? Reduce your exposure. It’s that easy.
If we were to bet our lives on a coin flip – “life or death, call it in the air! – we might say this bet was “unhedged.” Because there is no separation between the bet and the potential downside to our account (assuming no value to you if your dead), we have offered ourselves no protection. To have no hedge is to stand at the edge of a forest and proclaim it your garden. There’s a reason the “zerohedge” website has such eclectic visitors.
If I were to say, “heads I win, tails you lose,” that would be an example of being “fully hedged.” Because I’ve manipulated the rules so that loss is impossible for me (guaranteed for you in this case), I’m fully protected from a negative outcome. The real downside here is that nobody will want to play with me after they discover my ruse. The upside is that you can typically use this trick on kids multiple times before they catch on, making it an excellent parenting method for putting specific decisions up to seemingly uncontrolled chance.
Hopefully, now that you understand the word, you’ll also know how to basically interpret how others are using it. Remember to keep it simple, keep it visual (especially if that helps you), and beware of people making it sound more complex than it needs to be.