Hedging is the process of reducing a particular financial risk by adding an exposure intended to offset it. The objective is usually to make an existing holding, future purchase or future sale less sensitive to adverse market movements.
Start with the risk being protected
An asset holder might sell futures to reduce exposure to a price decline. A participant expecting to buy an asset later might buy futures against rising purchase costs. Options offer another approach: a purchased put can protect against some downside while requiring a premium.
The appropriate instrument, quantity and time horizon depend on the original exposure. A short futures position that hedges an existing asset can become a new speculative position if that asset is sold and the futures remain open.
Protection is rarely exact
Spot and derivative prices may move differently, creating basis risk. Expiry mismatches, changing option sensitivity, execution costs and funding can also change the outcome. A derivatives hedge may require additional collateral even when the combined economic position is broadly protected.
Hedging can sacrifice favorable price gains or incur an explicit cost. Its success is therefore assessed against the risk reduced across the combined positions, not simply whether the hedge itself made a profit.