Hedging is simply an investment to reduce or mitigate the risk of adverse price movements in another investment. Hedging allows you to add some protection at a cost to your portfolio. Many large companies and investment firms will use hedging in some way or another. For example, an international freight company might hedge against the price of oil while a Global Investment Fund might hedge against any adverse movements in the exchange rate.

A large international airline company knows that it needs to buy jet fuel in the future to fly its planes. Therefore by taking an investment which benefits from the rise in the oil price means that this will offset any rise in the cost of fuel. If the price of oil falls, then the airline will be able to buy oil for its planes at a cheaper price, but its 'hedging' investment would show a loss. Hedging involves locking in a price which is achievable now to protect against adverse price movements in the future.

Hedging can be achieved at a variety of levels - from a single stock, right the way through to protecting a global portfolio of stocks and commodities.

Before looking at hedging further it's worth explaining the concept of 'shorting' in more detail. Shorting, or going short, is a way of potentially profiting from a decline in prices. Using products such as Contracts for Difference (CFD) or Spread Betting you are able to sell an instrument you don't own with the hope of buying it back at a lower price at a later time.

Shorting is usually used to speculate on a reducing price, but used with hedging you can use shorting as a way of taking out an opposite position to holding the underlying position, creating an overall neutral position. In other words you can use shorting within a hedging strategy to reduce risk. The opposite of shorting is 'going long'.

Mr. Smith has worked for Blue Chip plc for a number of years and has built up a substantial number of shares - holding these in his Selftrade Dealing account. He is showing a good profit and is confident that Blue Chip has a very healthy long term future. But recent market events have made Mr. Smith nervous about the stock market over the next 6 months.

Mr. Smith has a dilemma. If he sells his shares then he is going to consolidate a large Capital Gains Tax (CGT) profit, but if he just sits back he will see the value of his investments fall. Therefore, Mr. Smith decides to take out a short CFD position in Blue Chip which is the same size as his current underlying holding.

By shorting an equal number of CFDs in Blue Chip as the number of shares he owns, Mr. Smith no longer has an exposure to Blue Chip's share price. If Mr. Smith was correct about the market taking a wobble and Blue Chip's share price falling then the value of his underlying shares will fall. But his CFD position, which as a short benefits from a falling price, will offset this reduction.

If Mr. Smith's prediction of the market falling proves to be incorrect and Blue Chip's shares rally then the opposite will hold true. His underlying shares will rise in value, but his CFD position will show a loss. As he has created a 'perfect hedge' i.e. he took out exactly the same number of CFDs as the number of shares he owns, then this gain will totally offset the loss on the CFD position.

Mr. Smith was careful about choosing a CFD account to carry out the shorting element in the hedging strategy. As his Blue Chip shares are held within a Dealing account they are liable for CGT. Although subject to change and dependant on individual circumstances, CFDs are also liable for CGT.

Therefore in the above example, any tax implications on the gains on Mr. Smith's shares will be equally offset by his losses within his CFD account and visa versa. Therefore he not only created a hedge on his exposure to the share price of Blue Chip, but also created a tax implications hedge.

But what if Mr. Smith held his Blue Chip shares within a Shares ISA or SIPP Dealing account? If he used a CFD account to hedge his shares exposure within one of these accounts then a fall in share price and the associated profit within his CFD account would be subject to CGT. To avoid this scenario Mr. Smith could perform the short element of his hedge in a Spread Betting account. Spread Betting works in a very similar way to CFDs - Mr. Smith takes a short spread bet position of an equal size to his underlying share holding in Blue Chip.

Therefore to create a 'perfect' hedge within a Shares ISA or SIPP Dealing account you can take a short position using a spread bet.

Hedging is not exclusive to protecting a portfolio which is too concentrated in individual stocks. The table below shows how different exposures can be mitigated against by using the concept of hedging.

You have large exposure...	For example...	To hedge you would look at....	with a view to...	although consider...	but the advantage being...
...to a particular sector	After a review of your portfolio you realise you are overweight in the banking sector	Sector CFDs/Spread bets	short the Banking Sector	your sector bet may not be fully representitive of your holdings	you can hedge all of your banking stocks with just one trade
...across a variety of FTSE 100 stocks	You like your core UK holdings, but think the overall market may fall back in the near term	UK 100 index CFDs/spread bets	short the UK 100 index	your index bet may not be fully representitive of your holdings	you can hedge all of your UK stocks with just one trade
...across international stocks	After being bullish on some US shares you realise that an adverse movement in $US would reduce your profit potential	Currency CFDs/spread bets	buying GBP/USD, therefore the hedge trade profiting from a fall in USD	your $US income is not certain, such as the expected dividends could change	you have significantly reduced your $US exposure with one trade

Hedging can also be used in a much wider context than just to protect positions within your Selftrade accounts. Maybe, like our airline example earlier you spend a significant amount of money on petrol. You can use CFDs or spread betting to take advantage of an increase in the price of oil, knowing that you will be paying more at the pump to fill your car up.

The price of gold has been a traditional hedge against inflation. Therefore if you think inflation may increase in the future and you subscribe to the gold/inflation link then you can take a long position in gold to reduce your exposure.

Selftrade CFD and spread betting accounts also offer you the ability to go long and short on interest rates - useful if you have a variable mortgage rate or if you receive an income from interest on cash which would be impacted from decreases in interest rates.

Hedging, by definition, is a concept used to reduce risk. But there are circumstances when hedging can be used to reduce the risk within a speculative strategy. Such an example is a 'pairs' trade. Consider Mrs. Jones who is bullish on Tesco - thinking it will outperform the overall market over the next few weeks.

By exclusively taking a long position in Tesco, Mrs. Jones would be speculating on the price of Tesco shares increasing. But if the overall market fell dramatically then the chances are it would drag down the price of Tesco. Tesco may only fall 2% against a market fall of 5%, but Mrs. Jones would lose money.

Therefore Mrs. Jones simultaneously places a long Tesco position and a short UK 100 trade. By taking out these trades Mrs. Jones is 'removing' market risk - the UK 100 being a close proxy for overall 'market risk'.

Mrs. Jones will profit as long as Tesco shares outperform the UK 100. If the market rallies tomorrow and all stocks rise, then she will make a profit on her Tesco shares and a loss on her short UK 100 trade. But as long as Tesco rises by a larger percentage than the UK 100 then this will be a profitable strategy.

Now imagine if the earlier scenario happens. The overall market falls by 5%, which will make her UK 100 trade more profitable, than the 2% fall in the Tesco shares which will have generated a loss. Mrs. Jones would only lose from this strategy if Tesco underperformed the UK 100.

Other 'pairs' strategies can involve taking a long position and a short position in two individual stocks, usually in the same sector e.g. GlaxoSmithKline and AstraZeneca. Taking a long and a short position decreases the impact of scenarios such as a large market correction and creates a pure one stock versus another play.

In order to gain a full understanding of the costs involved with hedging it is important to completely understand the concepts and charges of all of the account types involved, whether it be a Dealing, ISA, SIPP, Selftrade CFD, Spread betting or any other type of account.

Some key areas of consideration:

• Stamp Duty: Stamp duty is not charged on CFD and spread bets, but is generally charged on equity trades, especially UK shares.
• Deposit requirements: When you purchase shares you are required to place 100% of the consideration to open the trade, but with CFDs and spread betting you only have to place a fraction of the total consideration as a deposit e.g. usually 10% for shares and 2% for currencies. If positions move against you, you may have to make additional deposits which could exceed the initial deposit.
• Financing: There are no ongoing charges or credits with shares. With CFDs and spread betting there will be a daily financing charge applied to long positions, but you may be credited if you hold a short position.
• Dividends: Long positions across shares, CFDs and spread bets receive dividends. Short positions for CFDs and spread bets will result in your account being debited the dividend.
• Note, financing and dividends are not applicable for currency trades.

	Shares	CFDs/Spread betting
Selftrade commission	£12.50 per trade	CFDs typically incur a percentage fee on equities while commission for spread bets and CFD indices is included in the bid-offer spread. See the Market Information sheets for full details.
Stamp Duty payment	0.5% of total consideration	N/A
Financing payment on a long position	N/A	Yes
Financing credit on a short position	N/A	Yes
Dividends on long positions	Credited to you	Credited to you
Dividends on short positions	N/A	Debited from you

Hedging can be used to reduce or insure against your exposure in a whole variety of ways - from direct investments to more lifestyle expenditure. To hedge investments you already own you should be looking to 'short' the equivalent instrument within a CFD or spread betting account. To hedge against future purchases you will be looking to take a long position in order to benefit from the increase in price and offset any future price rises. Whether to perform the hedge as a CFD or a spread bet may be determined in some way by the tax position of your underlying investment.