Hedging involves limiting the risk of an investment to offset potential losses that may arise from it. It involves making an investment in various types of financial instruments that are expected to counteract the loss on an existing investment.
Assuming an investor wishes to buy Apple stock at USD 500. If Apple does well, its share price will rise and the investor will make a profit (capital gain). However, if it runs into some sort of difficulty, or publishes disappointing earnings, its share price will fall, and the investor will incur a loss.
To hedge completely against the risk of incurring a loss, an investor can purchase put options on Apple with a strike price of USD 500. This gives the investor the right to sell Apple at USD 500.
Thus, if Apple’s share price rises the investor will incur a gain, but if it falls below USD 500, He is protected on the downside, as his long position in the stock is offset by his short position resulting from the exercise of the put option. His pay-off will be as follows:
By hedging with a put option, the investor has eliminated his potential losses and can only benefit from the upside of the stock. In fact, he replicated the pay-off of a call option. However, putting on this strategy requires the purchase of an option with a premium, and ittherefore has a cost. In reality, in setting this strategy the strike of the put is likely to be set below USD 500. That is, if for example the investor wishes to limit his loss to a maximum of USD 50, he will select a strike price of USD 450. This would result in a similar pay-off to the one above, but shifted down along the y-axis.