How does hedging function within an investment strategy?

Hedging functions within an investment strategy primarily by protecting against potential losses. The main purpose of a hedge is to reduce the risk exposure of an investment or portfolio. By using various hedging techniques, such as options, futures contracts, or diversifying assets, investors can offset potential declines in the value of their investments. For instance, if an investor holds a stock and fears that its price might decrease, they might purchase a put option on that stock. If the stock price does fall, the gains from the put option can offset some or all of the losses on the stock. This protective measure allows investors to manage risk more effectively and stabilize their investment returns, even in volatile markets.

This focus on loss protection distinguishes hedging from strategies aimed solely at enhancing potential gains or maximizing capital appreciation. Effective hedging does not inherently seek to diversify investments, but rather to create a safety net against adverse price movements.