Hedgelet

On Wall Street, you might call it a hedgelet. On the Las Vegas strip, you'd call it a prop bet.

A hedgelet is a financial contract that allows you to bet on a particular event or outcome. They are often used to in relation to the release of an economic statistic (unemployment rate, GDP, etc.).

In Vegas, you might take the over/under of the number of free throws LeBron James will have in a playoff game. In the financial market, you can buy a hedgelet, which will pay off if GDP rises more than 2.0% in May.

Related or Semi-related Video

Finance: What is a hedge fund?41 Views

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finance a la shmoop. how does a hedge fund work? so you've probably heard a lot

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about the huge fees that hedge funds charge for the privilege of managing [woman looks shocked as hedge fund is advertised]

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your money. that hedge funds are only investing vehicles for the wealthy and

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how mathy their employees are. but the actual workings of a hedge fund are a

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lot like driving down a road in wartime. there are hills and there are valleys

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your car will Traverse wanting it to speed up and slow down but as long as

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you continue to drive 37 miles an hour the enemy radar can't detect you so you

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drive theoretically, safely down the road. alright so how does this translate to

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financial investments in a hedge fund well essentially every investment made

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on an entity going up in value is usually offset by making a bet on a

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different entity going down in value. that's called hedging got it? the economy

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is coming out of the doldrums and you believe the entire stock market is gonna

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recover but you believe the worst companies which have been down some 90% [chart showing decline]

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in this bad bear market environment will actually do better over the next period

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of time than high quality companies like Coca Cola which didn't decline as much.

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that is yes Coca Cola stock will improve and you think it has Headroom to run

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upwards some 30% in the next year and a half but you believe crap burgers

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dot-com which went from $100 a share at its peak to only $2 today could

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quadruple to 8 bucks in value over that same 18 months. like you get a much

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better percentage return on crap burgers than you do on coke. so as a hedge fund

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manager one quote easy unquote trade that you'll make is too short coca-cola

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betting essentially that it will go down, and then putting the same amount of

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money to being long crap burger com betting essentially that it'll go up. in

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essence the bet that you are making is that crap burger will go up a lot more [Coca-Cola and crap burger stocks in two separate baskets]

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than coca-cola will go up but if the overall market goes down

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well you'll be hedged in that you're short Coca Cola position will cushion

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the blow of crap burgers further demise and it's likely you're looking at crap

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burgers balance sheet and thinking well they have $2 a share in cash and no debt

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how much lower can they go .got it? hedge funds use stock options

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aggressively to manage risk in their portfolios the promise hedge funds make

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to investors is that their performance will be up and/or good whether the

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market goes up down or stay sideways. so another common hedge trade involves the

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use of put options on the market to protect the long trades the fund is

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making. specifically a hedge fund might find 3 S&P 500 stocks it really likes [ put option explained]

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and believes that they will be up significantly over the next two to three

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quarters earnings reports. but it's also nervous about nukes in North Korea in

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order to protect against a bomb going off and the whole market going down and

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ruining its investment performance, and yes there are bigger things to worry

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about then but that doesn't matter to hedge funds not their job. the hedge fund

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goes long the three stocks it likes but it buys put options on the market

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betting with those options that the market itself will go down. it's

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essentially playing both sides of the fiddle so that hopefully it wins in any

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set of circumstances. and yeah it's a lot more complicated than that in practice

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we're just given the idea here. in the case of a put option the market might be

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trading at ten thousand and a put option might have a strike price of nine

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thousand such that if the market declines below nine thousand the put [strike price illustrated]

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option goes quote in the money unquote and pays the investor handsomely for

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making the bet that the market would go from ten thousand and well somewhere

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below nine thousand. if that happened the three long stock bets that the hedge

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fund made would go down but their decline would be hopefully more than

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offset by the gains from the put options the hedge fund bought that were

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portfolio life insurance in the case the market puked. and if that happens well

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all you can really do is offer the market a breath mint and a moist

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towelette and then be sure to collect your fee. [person representing stock market offered towelette]

Find other enlightening terms in Shmoop Finance Genius Bar(f)