Hedging is a process used by investors to protect themselves from any unfavorable event in the future. In general, hedging is a strategy that is incorporated to protect your investment in the stock market and increase profits. For hedging, a person or entity needs another entity to enter into the strategy; these other parties are known as counterparties. There are different ways to cover an investment, however, they all consist of agreements between you and the third party.
Difference Between Insurance and Coverage
Insurance is a promise of compensation for specific potential future losses in exchange for a periodic payment. Insurance is designed to protect the financial well-being of an individual, business, or other entity in the event of an unexpected loss.
Coverage is a bit like insurance. The buyer of shares takes out the insurance of having a put option. It means that you cannot lose more than 20%. The speculator hopes to take advantage of the fact that the chance of stock prices falling is very low.
Hedging can be implemented in a variety of ways, including stocks, exchange-traded funds and insurance, forwards, swaps, options, many types of derivative and over-the-counter products, and futures contracts.
Hedging and insurance are risk reduction strategies. When you buy an insurance policy, you pay a premium to avoid risk without limiting your potential rewards. Hedging, on the other hand, is a financial strategy that involves giving up potential financial gain in order to avoid financial risk.
Coverage example:
Suppose you are a farmer and have a corn crop that will be ready to harvest in two months. A buyer offers to pay you $5 per bushel when his crop is ready. If you accept the offer, you lock in the price and are guaranteed to earn at least $5 per bushel, regardless of the market price when your crop is ready. In this case, he is protected against a future price drop below $5. However, your hedge also limits your earnings to $5, even if the price of corn sells for more than this amount when your crop is ready.
Insurance Example:
Now suppose that instead of offering you $5 per bushel of corn today, a buyer offers you a contract that gives you the right, but not the obligation, to sell your corn for $5 per bushel when it is ready for harvest. For this right, the buyer charges you $200. In this case, you are insured against a future price drop below $5 per bushel. However, if the market price of corn is above $5 when your crop is ready for harvest, you can sell it for the higher price; therefore, you insured against downside risk without limiting your potential profits.
Save up to 60% on private coverage insurance.