Hedge Fund definition

Hedging means covering yourself in case your primary plans go afoul. Speculators and investors use hedging to protect themselves when securities move in the opposite direction from what they had hoped. In this article you will get the detailed information about hedge fund definition in Stock market and playing effectively in stocks.

Hedging is a form of insurance in investment games. In some cases, hedges are designed simply to limit losses; but in others, they are designed to also multiply gains if an investment goes backwards. In stock and options investing, most hedges include long and short positions in stock and option combinations, or in option combinations. 

Risk Involved in Investment

Inherent risks in any type of investment make hedging a necessity. Regardless of your sophistication in stock and options investing, there are too many variables that are beyond your control, that you cannot possibly predict, and that will happen every time you have everything going for you.

Munn lists these risks as interest rate risk, market risk, inflation risk, business risk, financial risk, and liquidity risk. Interest rate risk is probably the least of these major investment concerns because interest rates are generally predictable and the astute investor keeps her wary eye on the prime rate and reacts to developments quickly. Falling rates are generally a plus for the market, and rising rates are generally a negative. Inflationary trends, too, are relatively predictable but business, finan­cial, and liquidity strength of corporations can change very, very quickly. New competition, drying markets, changes injthe executive suite, scandal, wars, even the weather can send income into a nose dive and corporate stock into the cellar. Just think of past investment disasters (unless you were a short seller): asbestos and Johns Manville, IBM and its changing marketplace, Digital Equipment and its marketing management, and Union Carbide and Bhopal.

 There are also other risks associated with hedge fund definition investing that can destroy any portfolio, no matter how solid the fundamentals of the securities it contains. These include governmental and political risk, war, defaults, and foreign exchange and expropriation risks.

 Buying Puts in Stock Market

Bullish investors sometimes like to hedge their long positions in stock with long positions in puts. Now, let's look at them from the perspective of the buyer, and then from the perspective of the hedging bull.

 

Bears buy puts because puts generally go up in value when the underlying stock goes down in price. It is a way for bears to profit very handsomely when the stock market tumbles.

In the next part, we begin looking at tools of the bull in detail. The first subject is buying stocks long, then buying calls long. Stock and options traders need to know how to hedge with puts.

  Profiting by Buying a Put

You have purchased one put on Merck stock for $300. The value of the stock when you purchased the put was $30. Before the expiration date of the contract, Merck slides to $25 per share. The put, meanwhile, has increased in value to $800. You decide to take your profits and, therefore, sell the put. Your profit is $500 ($800 - 300).

You never at any time were required to maintain any position in the underlying stock, but you profited as though you sold short 100 shares, for each put represents 100 shares of stock. How much would you have had to put up If you sold short 100 shares of stock? Given 50 percent margin, $1,500. How much did the put cost? $300.

If Stock Market goes Against You

The risks are somewhat more limited for put buyers than they are for short sellers of stock. This is because the stock can double or triple in price and losses can mount significantly. But the put buyer can only lose the amount he pays for the put plus commissions.

 But why would the bull want to buy puts when this is the bear's game?

Consider that the put usually goes up when the stock goes down (and down in price when the stock goes up). This means if you are long on the underlying stock, and the market goes against you, the put will cover part or all of your losses and possibly even let you come out a winner altogether. As puts can be expensive, generally investors hedge with very low-priced puts, hoping to make the profit on the stock., the lower-priced puts with the same expiration date and striking price are almost always the out-of-the-monies.

The best rule of thumb for buying puts is that if you are going to hedge, hedge with low-priced puts; if you are going naked, buy the higher-priced puts. As a bull, however, you will be much more interested in writing puts for additional income and in selling (writing) them as a hedge. Hedge fund definition gives you idea about hedging in the bull market.