How Does a Hedge Fund Work

The hedge fund gets its name because they seek to offset potential losses in the principal markets they invest in by “hedging” their investments using a variety of methods. A hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment. A typical example of a hedge is short selling. Short selling is the practice of selling securities the seller does not then own, in the hope of repurchasing them later at a lower price. This is done in an attempt to profit from an expected decline in price of a security, such as a stock or a bond. Another similar strategy consists of buying options known as puts. A put option consists of the right to sell an asset at a given price; thus the owner of the option benefits when the market price of the asset falls. Recently, the term "hedge fund" has started to be used when describe any fund that uses “hedging” methods. However, some funds only employ these methods to increase leverage and risk, and therefore return, rather than reduce it.