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Hedging strategies are different forms of financial plans that allow a person to avoid unwanted price fluctuations in one market by establishing an opposite position in a different market. The overall goal is to limit the amount of risk faced when investing in different types of securities. A number of financial vehicles exist to benefit investors interested in hedging the chances of a large loss in markets. These include different types of options, forwards, swaps and insurance. Generally, hedging strategies involve the establishment of hedge funds to prevent the loss.
Hedge funds are designed for shorter-term investments with the goal of making the largest return on investment in the shortest time. Instead of making a small amount of money over a long period of time, these diversified portfolios generally leverage successful securities against less successful ones, providing a large return with minimal risk. The main component of a hedge fund is the risk-return ratio, which can be analyzed by tracking the performance of certain markets over a specific period of time. Generally, hedge funds are only available to investors with a large percentage of financial assets at risk.
One of the primary components of hedging strategies is the concept of options. This enables investors to take a position that gives them the right to either buy or sell a certain asset at a specific price. The bonus of the options method is that the investor is not obligated to either sell or buy the financial security. Two types of options exist within this investment format: a put option and a call option. A put option gives the investor the right to sell at a given price, while a call option allows the investor to buy at a given price.
The concept of hedging strategies were formulated in 1949 by financial writer and sociologist Alfred W. Jones. He established the first hedge fund which focused on buying assets for the portfolio that would perform better than market expectations and sell products that did not meet his minimum criteria. This system essentially created a situation in which investors were more likely to generate a profit, while mitigating the likelihood of a loss. Over the years, additional research has shown that adding other components to the mix could also benefit the success of hedging strategies. Also, by taking out insurance plans on parts of the package against other financial securities, risk is further limited.