Hedge
An investment made to offset the risk of an existing position, reducing potential losses.
What is Hedge?
A hedge is an investment or strategy designed to offset or reduce the risk of adverse price movements in an existing position. It involves taking an opposite or negatively correlated position to an existing holding. Common hedging instruments include options, futures, forward contracts, inverse ETFs, and short selling. A 'perfect hedge' would eliminate all risk but also all upside; in practice, hedges reduce — not eliminate — risk while accepting some cost (the 'cost of hedging'). Corporations hedge operational risks: an airline might buy oil futures to hedge against rising fuel costs; an exporter might use currency forwards to hedge exchange rate risk. Individual investors might buy put options on their stock portfolio to hedge against a market downturn.
Example
Delta Air Lines regularly hedges its jet fuel costs using oil futures and call options. In 2008, Delta had substantial fuel hedges in place when oil surged above $140/barrel — the hedges saved the airline billions. However, when oil subsequently crashed, competitors with no hedges benefited from cheap fuel while Delta was locked into higher prices, illustrating the two-sided nature of hedging.