Hedging is using leverage to take an inverted position as insurance against an unfavorable outcome or investment.
For example, if a farmer was growing corn (and nothing else, for this simple example), the price of corn would have a direct impact on the farmer’s revenue from the sale of his corn. The farmer has continuous expenses, but he can only have up to one corn harvest per year. There are many ways for a farmer to hedge his interests and market his corn, but for this simple example let’s assume he will hedge against the price of corn:
If the price of corn rises, his corn is worth more, the farmer earns a profit, and he is able to pay his bills. But if the price of corn falls below his break-even point, he would not earn any profit and he may not be able to pay his bills. The farmer protects himself by using leverage to purchase a hedge against the price of corn. In this case, if the price of corn rises, he earns a profit on the corn and he loses the amount he spent on the hedge. If the price of corn falls, he loses money on the harvest but he earns a profit on the hedge, offsetting the loss. The cost of the hedge is insurance against corn prices.
Southwest Airlines famously hedged against increased fuel costs during the dramatic increase in 2005. Airlines consume vast amounts of fuel and they can rely on these costs being consistent in their operations, and a substantial expenditure. By using derivatives, they were able to secure their fuel pricing over the short term. When costs skyrocketed, substantially damaging other airlines balance sheets, Southwest was able dodge the bullet and enjoy a major competitive advantage.
The simplest hedge for a retail investor is to purchase a protective put option against shares held in their portfolio. If the share value declines, the effect on the portfolio would be negative, but the put option would increase in value substantially, creating an offset, and if done correctly, would secure the total value the of the portfolio.
Hedging can also be done against different companies or industries. If you had two opinions of competing firms (an opinion of a loser and winner), you could short the loser and bet the winner. They would hedge your exposure to the industry and/or market, while you would enjoy the upside of either one of your two opinions being correct.
Using beta, you could bet the upside of an aggressive stock or industry such as luxury brand, and then hedge this with a bet toward the upside of a defensive stock or bond.
This is a fundamental layer we needed to cover prior to discussing more complex financial strategies.