When most think of hedge funds they think of big fat cats sitting around in some office with billions at their disposal rolling the dice on risky futures and derivatives. While this might be true in some cases it doesn’t explain what a hedge, or a hedgefund does. And let’s start by eliminating the obvious… a hedgefund does not invest in thick bushes that line driveways 
Any investment can be considered a hedge if it helps to reduce the risk of overall loss due to a seperate (usually larger) investment.
The best way to think about a hedge investment is with an example that we should all know very well, cars and car insurance.
When one purchases a vehicle there are two financial sums at risk… the vehicle itself and the damage caused to others or yourself in an accident. It may happen that while I’m driving my $50k hummer down the highway I, oblivious to the rest of the world, crash into another Hummer (who is equally oblivious to the real world). Since the accident is my fault I’m now on the hook for my hummer, the other hummer and all medical bills… let’s say $200k all together. Luckily I hedged against catastrophic loss by taking out a comprehensive auto-insurance policy for $100 a month… they pay for everything. I’m free to return to my irresponsible hummer driving ways!
Notice that for $100 a month, my hedge has the ability to pay out $200k when a predefined event occurs, this is called leverage: the ability for a small sum of money to control a large sum.
Hedging is not limited to insurance though. In the stock market one can easily hedge against significant loss via Put and Call options. If I sell a Put option to some other investor, we’ve agreed that I can “put” my stock on him (sell it to him) for an agreed upon price. In exchange for the risk that the Put option buyer takes on, I agree to pay him a small fee…say 5% of my stock’s value. When my stock shoots up 10% the put option gives me no advantage and I keep my stock. But perhaps it loses 20%… I then shovel off the stock to the purchaser of the put contract for its agreed upon value. Now instead of losing 20%, I’ve only lost 5%.
Notice: 5% of the stock’s original value creates a contract to control 100% of it’s value. Again, we see leverage here.
A Call option works the other way, it is an agreement between me and a holder of some stock such that I can “call” him up and purchase the stock for an agreed upon price. In this case I pay the owner 5% to buy the stock at a certain price. When the price of the stock shoots up and above our agreed upon price by 20% I excercise my option to buy and purchase the stock for a 20% discount. If the stock fails to increase in value the owner of the stock makes a 5% profit and I lose the nominal value of the call option.
Again, for 5% I can gain control of 100%.
The essential feature here is that I can take on another’s risk or dish out some of my risk for profit. No problems here with massive default.
However, what if I don’t have stock to sell options on or the money to purchase the asset indicated in the contract? I can go naked! wooohooo!!
No not that kind of naked. Going naked means that you sell someone the option to “put” stock on you without having the money to pay for that stock (which would cause a default on your side). Likewise you can also sell the right for someone to “call” you on your stock. In both cases you collect the 5% fee, but you’d better hope that the conditions don’t force you to to have to purchase the requisite amount of stock in order to fulfill the contract[1].
Selling naked options is not hedging, it’s highly leveraged speculation and is ill-advised.
Hedging is not limited to what has been shown above. Almost any investment can be a hedge as long as it protects against loss from another investment … the possibilities are almost limitless, for example: biodiesel hedges against rising oil, hay bails against rising drywall costs, Japanese steel against American Steel, Apple vs. Microsoft etc.
Perhaps one of the most common hedges in the average person’s life (besides car insurance) is the common resume and occasional job application. That’s right, hedge against income and job loss by keeping one foot in the door of another company… it only takes a little bit of your time.
- this is called securities fraud and => jail [↩]