So, in order to be sensible about it, let’s ask ourselves what we’re hedging against – what are the RISKS involved in trading. In commodities, risk arises from the value of the asset due to increased supply, diminished demand, seasonal factors and so on. Credit risk would entail a share’s issuing company going bankrupt. Currency risk arises from geo-political factors, mainly, but also from a central bank’s reaction to economic factors. Volatility risk could result from one of these factors, but also from pure market mechanics: a sudden loss of liquidity, for example. Equity risk is the result of your asset simply losing value – primarily shares. And volume risk simply means that suddenly nobody is interested in the asset.

To each of these there is a response that’s unique to each sector. So, for example, export companies usually hedge their gains by exporting to several markets or spreading manufacturing to offset risk; commodities traders invest in futures contracts to offset currency and production fluctuations.

An investor might invest in two competing companies – going long on the better-performing company and shorting the lesser. If the industry as a whole improves or remains steady, profits on the former will be smaller, but so will losses if the industry fails. Ultimately, the investor would be sacrificing some profit but also lessening potential losses.

This is one example of diversifying your portfolio, and all good investors do that. Another possibility is buying high-grade corporate bonds in the same company you have shares in. Because a bond’s value is related to interest rates, the higher the interest, the more attractive the bond. On the other hand, the higher the interest rate, the less valuable a share becomes, owing to the increased cost of borrowing money. In addition, currency values usually increase alongside interest rates, making a company’s product more expensive abroad.

Vanilla options are one of the most popular instruments for hedging, and we’ll examine those in future lessons. Meanwhile, imagine you have shares in a company. You believe their value will increase, but just in case, you buy put options on the same asset -options that allow you to sell the asset in the future, but not an obligation. If the share goes up, you simply don’t exercise you option; if it goes down, you sell at the strike price.

Finally, investing in safe-haven assets is another means of hedging one’s portfolio. Gold, for example, maintains its relative value thanks to limited production. It’s priced in dollars, so that when one goes up the other comes down; and in times of stress, traders flock to gold, increasing demand on a limited supply. The result is gold going up when the rest of the world goes south.

Another simple way of hedging is investing in related assets. Canada, for example, is a major oil producer. If you open a position in oil, open a contrary position on the Canadian-US dollar. If oil goes up, the Canadian economy improves; if it goes down, the loonie deteriorates. Thus, if you open a buy position on oil, you could offset it with a smaller-scale sell on the CADUSD. If your position fails, you will be recouping some of your losses on the Canadian dollar. If you succeed, your loss on the CADUSD will blunt the sting.

The long and the short of it is simple: diversify your portfolio, and always be prepared for the worst. Never presume that a position is a sure thing. Chances are that the surer you are, the more you need to hedge it.