If an investor is long the stock of a particular company but due to short term losses suspects the price will drop, buying a ‘put option’ is one of the ways to hedge against potential downside risk. Investors can protect their investments from potential losses by entering derivative contracts whose gains will offset the losses realized in the event of unfavorable price movements. ![]() A futures contract on the other hand obliges the holder to buy or sell a specified amount of an asset at a predetermined price with an agreed expiry date at which the contract must be fulfilled. An option is a financial contract which gives the holder the right to buy or sell an asset at a given price known as the strike price within a specific time period. Options and futures contracts are the two commonly used derivative securities in hedging investments. Portfolio managers, individual investors and companies enter into derivative contracts to reduce their exposure to adverse price movements. One of the common forms of hedging is through derivative contracts. ![]() An everyday life example is car insurance which hedges the driver against car theft and accidents among other risks. In the event where the unforeseen circumstance manifests itself, a properly hedged position reduces the potential losses that could have been realized. Hedging can best be thought of as a form of insurance against unforeseen circumstances which may have financial ramifications. ![]() Hedging through diversification involves investing in a variety of stocks whose performances are not affected by the same risk factors.Investors can use hedging strategies to limit losses in one investment by realizing gains in another investment.Derivatives are financial instruments whose value depends on an underlying asset or group of assets.Hedging strategies can limit the risk of loss but also limit the profit potential of a given investment through the use of derivative contracts.Hedging is a financial risk management strategy used by investors to potentially offset losses in their investments by taking opposite positions in the same or related assets.
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