The word of the week for this week is hedge. This word is very important for investors who may have a large position in a stock, and believe that the price of it may start moving in an unfavorable direction.
Suppose that a company owned 10,000 shares of Netflix. They bought the stock 6 months ago at $15/share for a total investment of $150,000. Since then, the stock has doubled up to $30, which gives them the value of their Netflix holdings to be $300,000. Now they would like to continue to hold the stock, but the company predicts that the economy may not be as strong as usual, and this could have a negative effect on the price of their stock. In order to protect against these losses, the company purchases protective puts with a strike price of $30 for June 2008. These puts cost $3/share. Each contract is for 100 shares, and the company purchases 100 of these contracts for a total of (100 contracts x 100 shares/contract x $3/share = $30,000). These options give the company the option, but not the obligation to sell all of their shares at $30 per share before June 2008 regardless of the current market price. If the price of the stock rises, then the options will expire worthless.
Let’s imagine though that by May 2008 the price of Netflix has dropped from $30/share to $20/share. Without the hedging that the company did, the value of their Netflix holdings would be only $200,000. This is a loss of $100,000. With the options, they could exercise them at the $30 strike price for the total value of $300,000. The only cost to them would be the $30,000 insurance policy that they took out. By using the options, the company will sell at a realized value of ($300,000 - $30,000 = $270,000). this is $70,000 more than what they would have had if options were not used.
So as a definition, hedging is essentially an insurance policy that companies take out in order to lock in profits.