What is hedging in trading: Techniques, Benefits & Real Examples

Hedging is a financial strategy used to protect against potential losses by taking an opposite position in a related asset. The main aim is to reduce risk, not to make extra profit.

Kanta Singh owns 100 shares of Company X, which she bought for ₹500 each, totalling ₹50,000. She’s worried the price might drop, so she buys a put option that lets her sell the shares at ₹480, paying a ₹5 premium per share (₹500 in total). 

If the price falls to ₹430, the option helps her limit her loss to ₹2,500 instead of ₹7,000. But if the price rises to ₹550, she still makes a profit of ₹4,500 after the premium. The hedge protects her from big losses while still letting her earn if the price goes up. 

In this blog, you’ll learn what hedging in trading means, explore key techniques, understand its benefits, and see real examples, so you can start applying these ideas with more confidence.

Common Hedging Techniques & Instruments

There are different ways to hedge depending on the kind of risk you want to reduce. This could be changes in prices, interest rates, or currency values. Below are some of the most common methods, with clear examples to show how they work in real life.

1. Futures and Forward Contracts

Futures and forwards help you fix prices for something you plan to buy or sell in the future.
 

• Forward contract example: A cotton mill agrees in January to buy 10,000 kg of cotton at ₹200 per kg for delivery in July. If the market price in July goes up to ₹250, the mill saves ₹5,00,000. But if the price drops to ₹150, the supplier benefits instead.
   
• Futures contract example: A wheat farmer expects to sell 5,000 bushels. He sells futures at $6.00 per bushel. If the price drops to $5.00, he earns $5,000 through the futures. This makes up for the lower selling price in the market.
   

Note: A bushel is a standard unit used to measure volume, mainly for crops like wheat or corn, roughly equal to 27 kilograms for wheat.

2. Options Strategies

Options help you protect your investment without the need to fully buy or sell the asset. They give more flexibility.
 

• Protective Put: Kanta Singh owns 100 shares at ₹500 each. She buys a put option with a strike price of ₹480 for ₹5 per share. If the share price falls to ₹430, she limits her loss to ₹2,500. If the price rises, she still makes a profit, just ₹500 less due to the cost of the option.
   
• Covered Call: You own shares at ₹50 each and sell a call option with a ₹55 strike price for ₹3. If the share price stays below ₹55, you keep the ₹3. If it rises above ₹55, your profit is limited but still safe.
   
• Collar: You buy a put option to protect against losses and sell a call option to help cover the cost. This creates a floor and ceiling on your return. It suits investors who want low-cost protection.
   
• Risk Reversal: You buy a call option and sell a put option at different strike prices. This can protect you if the market moves in one direction. It often costs little but does involve some risk.

Options are flexible and can fit different needs. However, they require planning and come with some costs

3. Swaps and Currency Hedges

These help businesses manage currency and interest rate risks.
 

• Currency hedge example: A company expects €1 million in six months. To avoid losses if the euro weakens, it locks in a rate of ₹90/€, ensuring it gets ₹90 million. Even if the rate drops, the company is safe. But if the euro gets stronger, it misses out on extra profit.
   
• Interest rate swap: A company with a floating-rate loan might swap it for a fixed rate to avoid paying more if interest rates rise. This gives cost stability, though sometimes at a price.
   

Swaps are useful for long-term planning, but they’re mostly used by larger firms.

4. Natural Hedging and Diversification

Sometimes you can hedge without using contracts or tools, just by planning wisely.
 

• Natural hedge example: A company that earns in US dollars can take loans in US dollars. This way, income and repayments are in the same currency, removing the risk of exchange rate changes.
   
• Diversification: An investor spreads money across different assets, like stocks, bonds, or gold. If one goes down, others may go up. This balances the overall risk.
   

This method is simple and low-cost, but may not fully protect against big market changes.

Quick Comparison Table:
 

Hedging doesn’t remove all risk, but it helps reduce uncertainty and protect against large losses. The right method depends on your goals, the asset involved, and how much protection you need.

Important terms

Understanding key terms can help you grasp hedging concepts more easily. Here are some important terms explained simply:
 

Knowing these terms will help you better understand and use hedging strategies effectively.

Conclusion

Hedging is a smart way to reduce financial risk by using tools like futures, options, swaps, or even simple planning. It doesn’t remove all risk, but it gives you more control and helps protect your money from sudden market changes. If you are an investor, trader, or business owner, learning how to hedge can make your decisions safer and more confident.

FAQs

1. Can I hedge without using complex financial tools?

Yes. You can use natural hedging by matching your income and expenses in the same currency or by spreading your investments across different types of assets. It’s simple and often low-cost.

2. Is hedging only for big investors or companies?

No. Anyone can use hedging. Even individual investors can use options or diversify their portfolios to manage risk.

3. Will hedging always protect me from loss?

Not always. Hedging reduces risk, but it does not guarantee profits. It helps limit losses but may also reduce your potential gains.

4. What is the biggest mistake to avoid when hedging?

The most common mistake is using a hedge without understanding how it works. Always know the cost, the risk, and what you’re trying to protect before choosing a hedge.
 

Apply for Loans Fast and Hassle-Free

Apply Now

About the Author

LoansJagat Team

‘Simplify Finance for Everyone.’ This is the common goal of our team, as we try to explain any topic with relatable examples. From personal to business finance, managing EMIs to becoming debt-free, we do extensive research on each and every parameter, so you don’t have to. Scroll up and have a look at what 15+ years of experience in the BFSI sector looks like.