I’ve hard of “hedging” when someone wants to “lock in” a position’s profit, without selling the stock. I was told this is for tax reasons because if you hold the stock over a year you get taxed lower.
But doesn’t that require additional capital? Do I use options?
In: 3
Yes, you use options.
We’ll use an example that is most common – hedging currency risk. Let’s say that I make widgets in the US and sell them to a European customer. They want to pay in Euros, so we agree to sell them 1M widgets for 1M Euros in 6 months’ time. I spin up my factor and start making my widgets.
Right now, 1M Euros is worth 1.06M USD, but that could change six months from now. If I need to make at least 900k USD on the sale or I lose money, I might be very concerned that the exchange rate will change so much that I’ll lose money on the deal (since the 1M Euro price is agreed to already). That is currency risk.
To resolve this risk, I go out and buy an option to sell 1M Euros for 950k USD – this way, no matter what happens to the price in 6 months I am _guaranteed_ to get _at least_ 950K USD for my 1M Euros. If the exchange rate is worse for me I use my option, but if it is better I let my option expire and just use the current exchange rate.
This has _hedged_ my currency risk – I have locked in the _minium_ amount of revenue I can make on the deal at 950K USD.
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