Hedging is a trading strategy designed to reduce or eliminate the risk of adverse price movements in an investment portfolio. By strategically taking offsetting positions in related financial instruments, traders can protect their investments from potential losses due to market volatility, economic changes, or unexpected events. Hedging doesn't eliminate risk entirely but mitigates it, making it an essential component of risk management in trading.

One of the most common hedging strategies involves the use of options. For example, an investor holding a long position in a stock may purchase put options on that stock. If the stock's price declines, the gain from the put options can offset the loss from the stock, thereby reducing the overall impact on the portfolio. This approach is known as a protective put strategy.

Another popular hedging technique is the use of futures contracts. Traders might use futures to lock in prices for commodities, currencies, or other assets, protecting against unfavorable price movements. For instance, a company expecting to receive payments in a foreign currency may use currency futures to hedge against exchange rate fluctuations, ensuring stable revenue despite market changes.

Hedging can also involve more complex strategies, such as using pairs trading, where a trader simultaneously buys and sells related assets to hedge against sector or market risks. For example, buying a stock in one company while shorting a similar stock in the same industry can protect against industry-wide downturns while allowing for profit from the relative performance of the two stocks.

While hedging can reduce risk, it often comes at a cost, such as the price of options premiums or potential missed gains if the market moves favorably. Therefore, successful hedging requires a deep understanding of the underlying assets, market conditions, and the specific risks involved. When done correctly, hedging strategies provide traders with a safety net, helping to stabilize returns and preserve capital in uncertain markets.