When we use the word hedge, we are referring to reducing our risk. When we hedge a trade, we are limiting our profitability while at the same decreasing the amount of risk we are taking. An example of limiting profitability while reducing risk is selling a vertical call spread instead of just selling a naked call. While the call spread does not have as high of a probability of profit as the naked call, it has much less risk due to the “hedge” in place (the purchase of the long call).
We will hedge our positions when there is a change in our initial assumptions of the underlying and we will also hedge as a means of extending our duration on a trade. In general, a hedge is a trade that will profit if our initial position is violated even further. For example, if we sold a naked call in an underlying, then we would have a short position. If our call is tested and we wish to hedge our call, we would place any trade that adds positive (long) deltas. This means we could do anything from selling a put to buying stock.
In short, a hedge is anything that profits when our original trade loses.
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