Hedging is not Diversification
It is important to note that hedging is not the same as portfolio diversification. Diversification is a portfolio management strategy that investors use to facilitate specific risks in an investment, while hedging helps reduce a person’s losses by taking offsetting positions. If an investor wants to reduce his overall risk, he should not put all his money into an investment. Investors can spread their money to multiple investments to reduce risk.
For example, suppose an investor has an investment of $ 500,000. Investors can diversify and put their money into multiple stocks in various sectors, real estate and bonds. This technique helps diversify the risk that is not systematic; In other words, it protects investors from being influenced by any individual event in the investment.
When an investor is worried about an adverse price drop in his investment, he can hedge his investments in an offsetting position to protect himself.
For example, suppose an investor is invested in 100 shares in an oil company, LIO and feels that the recent decline in oil prices will have an adverse effect on his earnings. Investors do not have enough capital to diversify their positions; Instead, he decided to hedge his position by purchasing an option contract to protect his position. He can buy an option to protect it from falling stock prices; investors pay a small premium for the option. If the LIO fails to meet the earnings forecast and the price falls, the investor will lose money in his long position, but will make money with the put option contract, which limits the loss.