>…diverse away…
I think you mean ‘diversify’. Once you have the correct word, googling should be easy.
Nonetheless, I’ll give you an introductory comment or two…
The term hedging comes from the idea of putting a bunch of bushes or a ‘hedge’ around a property. It became used in the world of finance to describe putting limits on movement in the value of something.
**The most direct way of hedging is to have a contract in which you explicitly pay someone else to take a position that will limit your potential losses.** For example, if you are growing potatoes, and you produce them at a cost of 20 cents per pound, you must sell them for at least that much. If the price drops to 19 or less, you are screwed.
So you pay someone to have a contract with you that says in the future, on a specified date, he will buy X pounds of potatoes at 20 cents per pound – if you want to sell them. If the price does go below 20, you take no loss. He does.
You, of course, have to pay him a small fee to accept such a risk. If he is really wealthy, or has a bunch of wealthy investors, he can absorb such a loss without going broke. In the long run, he hopes to collect lots of money in fees for signing such contracts, and pay out less in buying overpriced commodities. The important idea here is that a large investor ( the hedge fund manager ) can survive losses that would bankrupt the small potato farmer.
**Another way of hedging is to have investments that react in opposite directions in response to radical changes in the market.** ( this is known as diversification ). Suppose that you own a bunch of rental property in a low-lying coastal area. In good times, you do well. But when the whole coast gets flooded, you are screwed.
So, to diversify, you buy stock in Home Depot. If the weather is decent, both kinds of investment will probably generate a modest profit. But when the hurricanes come in and wreck your properties, you lose money on them, but you make more than normal on the Home Depot stocks as people buy a lot there to rebuild their damaged homes.
The reverse is also true. If there is an abnormally long period of good weather, your Home Depot stock may decline a bit, but your properties will do well.
Note that the underlying idea is that outside forces can make the value of your investments go up or down. ( Outside forces can be competitors, the weather, government regulation, etc ) A prudent investor asks himself what is the worst thing that could go wrong, then ‘hedges’ his investment so that he can’t lose too much.
EDIT: If you choose to cash in your futures contract because the price of potatoes drops, the seller of the futures contract does not actually take physical possession of the potatoes. He just honors his contract by paying you the difference. If potatoes have dropped to 15 cents per pound, he pays you 5 cents per pound ( 20 – 15 = 5 ) and you still sell the potatoes.
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