Hedging is a risk management strategy where uncorrelated or low-correlation investments are grouped into a portfolio. The resulting combination of investments is intended to create more balance and lower portfolio volatility.
Investors hedge with a variety of strategies, like adding an uncorrelated stock position, buying a put option to limit downside exposure, selling options to reduce cost basis in the stock position, using a multi-leg option strategy to define a range of potential outcomes, or some combination of hedging alternatives.
The advantages of hedging stock positions include stabilizing portfolio returns and limiting downside risk. Disadvantages of hedging may include lower upside potential (due to the hedge’s cost) and the risk that the hedge does not fully protect the portfolio as expected.
Hedging typically comes at a cost. If the hedge is unnecessary--the stock position appreciates and no downside protection was required--the cost reduces the original trade's profitability.
For example, if a put option is purchased in an attempt to hedge a stock position, and the stock gains value, the cost of the put option somewhat offsets the appreciation in the stock position. In the risk/reward spectrum, if all risk is “hedged away,” virtually all potential reward will be. Thus, to hedge is to compromise.