Hedging vs just betting less

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  p1This is a question from a layperson about the fundamental concept of hedging, with regards to investing, gambling, and any situation in which hedging is used to manage risk.p2p1I do not understand why hedges are used as a risk management tool. Could the same reduction in risk not usually be achieved by simply betting/investing a smaller amount? I could imagine a situation where hedges would make sense - for example, where there is a minimum bet/investment that one is forced to make. But I get the impression that people use hedges all the time, even when there is the option of simply betting a smaller amount. Is it because risk in investing is measured as a percentage instead of a dollars-and-cents outcome? Or is it irrational, and related to the fact that hedging is simply more exciting than betting less?p2p1In short: Why manage risk by hedging instead of managing risk by simply betting less?p2
  p1Let's say I win a contract to supply widgets. The contract is for $600K.p2p1Unfortunately I need 6 months to make the widgets but I've negotiated and I'll get paid $100K every month as I manufacture the widgets till I've supplied all I'm supposed to.p2p1So far so good but I'm not located in the US and I need to pay my workforce in some other local currency. What happens if the dollar declines against that currency? I might not make any profit, worse I might not be able to pay the workers to continue making widgets.p2p1So I hedge against the adverse currency movement. I contract to buy local currency for dollars upfront at an exchange rate defined today but at times in the future when I'll need the money. I'm now covered if the exchange rate moves against me. I can still pay people to make widgets and make the profit I wanted and as long as I continue to deliver widgets I'll get the money in dollars that I need to exchange.p2p1Here I've eliminated currency exchange risk from my operation.p2p1Airlines often do this with fuel which they need to pay for in dollars despite selling airline tickets some time earlier in local currencies.p2p1In these cases there aren't any bets that you can bet less on.p2
  p1There are many kinds of hedges and many different circumstances where one could employ them. Let's look at some random option scenarios for investing in Coca Cola (stock symbol KO):p2p1I buy 100 shares for $50.70 and I have the potential to make any amount that KO rises and lose any amount that KO drops.p2p1I buy 50 shares for $50.70 and I have the same risk/reward ratio (R/R) as #1. Buying fewer shares just linearly reduces the quantitative amount of the profit and loss (PL).p2p1I buy 100 shares for $50.70 and I buy one Jan '22 $50 put for $4.80. In almost one year, make anything that KO rises above $55.50 I can lose no more than $5.50, no matter how far KO drops.p2p1I buy a 100 shares and add a $35p/$65c no cost option collar. I have the potential to make $15 (plus some/all of the dividends) with a maximum loss of $15.p2p1I buy the Jan '22 $52.50 call and sell one Jan '22 $62.50 call. This bullish vertical spread costs $2.35 and that is the most that can be lost in 11 months while having the potential to make $7.65.p2p1I buy the Jan '22 40 call for $11.20. That's a premium of only 50 cents over the cost of the shares but since share price is reduced by the amount of the dividend on the ex-dividend date, KO must rise 50 cents plus the amount of the dividend to break even. So for this one it's $11.20 of risk with open ended upside profit potential.p2p1I'm not suggesting that the hedges are better or worse but what they do accomplish is that they alter the risk/reward, often quite favorably. Hedging mitigates risk.p2
  p1Anybody can bet a smaller amount. You can reduce your risk to zero if you bet nothing. But then you'll gain nothing.p2p1As other posters have said, there are many forms of hedging. Sometimes they are used to reduce the risk of something going badly wrong when making a speculative investment.p2p1Suppose you are about to short a stock. You think it's going to go down in price and you will make a tidy profit. But you have a nagging feeling that it might turn out to be the next GameStop and you'll be left shorting a stock that suddenly goes up.p2p1You can hedge your risk by buying options on the same shares that you're about to short. If the shares do go down, you make money on the short position, and you discard the options. If the shares go up, you exercise the options, to buy the shares to rescue your position.p2p1Taking out the options costs you a bit of money, but saves you from the risk of a catastrophic loss.p2
  p1In its pure form, hedging is used to mitigate an existing risk that is inherent to some substantive (not just financial) activity. People work to provide for their families, so they often need life insurance. Firms produce and use physical commodities, so they often need futures contracts to protect from adverse price fluctuations. These activities have value in themselves and are not just bets. Of course, hedging is only possible because there are also speculators to take the other side of the trade. The relation between hedging and speculation is further discussed here.p2
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