Hedging
Hedging is opening a position that is expected to gain when another of your positions loses, reducing your overall risk.
A hedge is insurance for a position. You keep the exposure you want, and add a second position that gains if the first one loses. Farmers do it to lock in crop prices, companies to fix currency rates, and investors to protect portfolios through uncertain periods. Hedging reduces risk, but it is never free: it costs a premium, gives up some upside, or both. This entry explains the main hedging tools, how to size a hedge, and how to judge whether it is worth the cost.
- Category
- Trading Strategies
- Reading time
- 6 min
- Also called
- Hedge, Hedging strategy, Protective put
- Updated
Hedging in plain words
Suppose you own shares and worry about a fall, but you do not want to sell. You can buy a put option, which rises in value as the shares fall. If the fall comes, the put offsets much of the loss; if it does not, you lose only what the put cost. See Options.
Producers and consumers do the same with futures: a wheat farmer can sell futures to guarantee a price for the harvest, limiting the risk of losing money if prices fall.1 See Futures Contract.
How to hedge, step by step
Name the risk
What exactly are you protecting against — a fall in one stock, the whole market, a currency, a commodity price?
Choose the instrument
Options (puts for long positions), futures or perpetuals (short to offset a long), or an inverse position in a closely related asset.
Size the hedge
Match the hedge to the exposure you want to cover: for example 10 futures contracts of 5,000 bushels to cover a 50,000-bushel crop.1
Know the cost
An option costs its premium, which is lost if the hedge is not needed.2 Futures hedges remove upside as well as downside, and perpetual hedges pay or receive funding. See Funding Rate.
Check basis risk
If the hedge does not track your position exactly, the two can move differently. See Basis.
Plan the exit
Decide when the hedge will be removed — at a date, an event, or a price — so it does not become an accidental bet.
Worked examples
Example 1 — A protective put
OptionsYou own 100 shares bought at $50 and buy one $50 put for $2 a share ($200). The stock falls to $40.
| Shares | 100 × −$10 = −$1,000 |
| Put: ($50 − $40) × 100 − $200 | +$800 |
| Total | −$200 instead of −$1,000 |
The put capped the loss at its cost. If the stock had risen to $60 instead, the total would have been +$800 rather than +$1,000 — the price of the protection.
Example 2 — A producer’s futures hedge
FuturesA farmer expects 50,000 bushels and sells 10 wheat futures at $3.50. At harvest, wheat is $3.00.
| Crop sold locally | Lower by $0.50 a bushel |
| Futures bought back | +$0.50 × 50,000 = +$25,000 |
| Effective price | ≈ $3.50, as planned |
Following the CFTC’s example, the futures gain offset the lower crop price.1 Had prices risen, the farmer would have lost on the futures and gained on the crop — still ending near $3.50.
Example 3 — Hedging crypto with a perpetual
PerpetualAn investor holds 2 BTC at $60,000 ($120,000) and shorts 2 BTC of perpetuals for a month. BTC falls to $51,000.
| Spot holding | −$18,000 |
| Short perpetual | +$18,000 |
| Funding (paid or received) | Depends on the rate during the month |
The hedge neutralised the price move. Its cost or income came from funding, which turns into a cost when rates are negative.3
A protective put at three prices
Common hedging tools
| Aspect | How it hedges | Main cost |
|---|---|---|
| Buying a put | Gains as the price falls | Premium, lost if not needed2 |
| Shorting futures | Offsets the position fully | Gives up upside; margin calls1 |
| Shorting a perpetual | Offsets crypto price moves | Funding when negative; liquidation risk3 |
| Inverse or related asset | Gains when the main risk hits | Basis risk; imperfect tracking |
| Reducing size | Less exposure | Less upside; simplest option |
When hedging makes sense
Locking in prices
Producers and consumers fix future prices to run their businesses with more certainty.1
Protecting a long-term holding
Investors who do not want to sell can hedge through earnings, elections or other events.
Isolating a view
A trader who likes one stock but fears the market can hedge market exposure with index futures. See Pairs Trading.
Managing taxes or lock-ups
When selling is costly or not allowed, hedging reduces risk without a sale.
Advantages and disadvantages
Advantages
- Reduces losses from specific, identified risks.
- Lets you keep positions you do not want to sell.
- Can make outcomes more predictable for businesses and investors.
Disadvantages
- Costs money (premiums, funding) or gives up upside.
- Imperfect hedges leave basis risk.
- Over-hedging can turn protection into a new speculative bet.
- Adds complexity, margin requirements and more positions to manage.
Going deeper
Read as far as you need. Each level builds on the one before it.
A hedge is not a profit strategy
Beginner
A good hedge often loses money — that is what happens when the thing you insured against does not occur. Judge it by how well it reduced risk, not by its own profit.
Hedge ratio
Intermediate
The hedge ratio is the share of a position that is hedged. Hedging 50% of a portfolio halves the protection and the cost. For related but different assets, the ratio is often adjusted for how strongly they move together. See Beta and Correlation.
Delta hedging
Advanced
Option dealers hedge the exposure of options they sell by trading the underlying asset in proportion to the option’s delta, and keep adjusting as delta changes. This dynamic hedging can itself move markets near large option positions. See Option Greeks.
Common mistakes
Hedging after the fall
Protection bought in a panic is expensive; plan hedges before events.
Forgetting to remove the hedge
A hedge left in place after the risk passes becomes a separate bet.
Ignoring basis risk
A hedge that does not track your position can lose at the same time as the position.
Over-hedging
Hedging more than the exposure creates a net position in the opposite direction.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- A hedge is a position that gains when another position loses.
- Options cap losses for a premium; futures lock in prices but remove upside.
- Perpetual hedges in crypto cost or earn funding.
- Size the hedge to the exposure and watch for basis risk.
- Judge a hedge by risk reduced, not by its own profit.
Frequently asked questions
Is hedging worth it for small traders?
Does hedging guarantee no loss?
What is the difference between hedging and diversification?
Further learning
- Options
Puts are the classic hedge for long positions.
- Futures Contract
How producers and portfolio managers lock in prices.
- Funding Rate
The cost or income of hedging with perpetuals.
- Position Sizing
Sometimes the simplest hedge is a smaller position.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- U.S. Commodity Futures Trading Commission. Economic Purpose of Futures Markets and How They Work (opens in a new tab) Checked .
- Investor.gov (SEC). An Introduction to Options – Investor Bulletin (opens in a new tab) Checked .
- IG. How funding rates work in perpetual futures (opens in a new tab) Checked .
Read more elsewhere
- Investopedia: Hedge (opens in a new tab)
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. We are not affiliated with any publisher linked above. Last reviewed . Report an error or request a source credit.