Hedging means cancelling something by doing something else. When investments are concerned, hedging means taking the opposite position to the one that an investor currently holds. The final outcome is similar to closing the original position.
In general, hedging means cancelling something by doing something else. For instance, if someone says "the market will go up" but then adds "unless it goes down or trades sideways", then the latter causes the former to be meaningless. The market has to either go up, or down, or trade sideways (ok, it can implode, but that is another matter), so in the end the above statement says absolutely nothing about the market. In other words, not saying anything would be equal to saying the whole phrase.
When investments are concerned, hedging works in the same way, only the instruments are different. For example if you own one stock of Barrick Gold Corp. and then you short one stock of Barrick Gold Corp., your portfolio will not be impacted by moves in Barrick's share price - just like you didn't own Barrick share at all. That is the case, because any gain on the stock will equal the loss on the short position, and vice-versa. In this case, selling one stock of Barrick Gold short in order to offset any gain/loss on the stock that you own, is hedging.
Hedging can - and usually is - done using derivatives - futures or options. For instance, if gold futures have 5x leverage, you can either buy gold for $1000 or buy gold futures for $200, and when price moves, the end effect will be the same for your portfolio (at least in the short term). However, if you want to hedge gold worth $1000, you only need to short the futures contract for $200. Hedging could be utilized also using short ETNs - for instance DZZ is a double-short ETN, which means that if gold moves down, this ETN moves up by twice as much percentage-wise.
So, why bother with hedging, if you can simply close original position? Because in the end, it can save you money. It can work in a few ways, and the most important ones are:
- The commission for derivatives (mostly futures or options) is usually lower than commission charged on stocks,
- Tax issues: it may be more convenient not to sell your long-term holdings because that could mean significant tax burden for the current tax year. In case using derivatives to hedge your position might be a better option,
- There may be a precious-metals-market-specific benefits, because of the strong bull market in the sector. That's the case with options. Options can ensure that you get back on the long side of the rising market - the fact that options have time value can be seen as an advantage (yes!) if you use them to hedge your long positions. It’s counterintuitive, as the time-decay causes options to lose value, but we really think that it may prove profitable for some investors. The reality is that when people get out of the market, they sometimes fail to get back in at lower prices, as they start feeling the same emotions as other market participants. The prevailing emotion after a sell-off is fear, which prevents people from reinvesting in the shares they have just sold. After shares start to rally, people wait for a pullback, which either doesn't come or even if it does, it doesn't seem to be deep enough to make them purchase their favorite PM stocks. Finally people often get back into the market at prices higher than those at which they sold their shares in the first place. Since options have a "time limit", it means that you will get back your exposure to rising gold and silver prices rather sooner than later. Although this theory is questionable, we view this feature of put options as highly practical.