You may want to keep an investment while reducing its exposure to a particular price movement. A business might have a similar need: making a future currency payment or purchase cost more predictable.
Hedging addresses these situations through a position or arrangement designed to offset a specific financial risk. The useful starting point is knowing what you want to protect, for how long and at what cost.
Table of Contents
What do you mean by a hedge?
A hedge is a position or arrangement intended to offset an unfavourable movement in another financial exposure. Hedging is the process of establishing that protection.
For example, an investor holding shares might buy a put option on those shares. If their price falls below the option’s strike price, its expiry payoff can offset part of the loss. The aim is to manage the original exposure, so the investment and hedge should be assessed together.
Source: Securities and Exchange Board of India (SEBI), Understanding Derivatives.
Key Takeaways
- Hedging aims to reduce a specific financial exposure rather than guarantee profits or remove every risk.
- Futures, forwards, options and swaps provide different ways to manage price, currency and interest-rate exposures.
- A hedge’s effectiveness depends on how closely its underlying asset, size and duration match the exposure.
- Premiums, transaction costs, margin requirements and limits on gains affect the combined result.
- Diversification spreads investments across holdings, while a targeted hedge addresses a particular risk.
What is hedging in trading?
Hedging in trading involves taking a position that reduces risk associated with an existing or anticipated holding or commitment.
An equity investor might sell suitable index futures to reduce exposure to a broad market decline. A business expecting a foreign currency payment might use a permitted forward contract to agree an exchange rate.
The purpose distinguishes hedging from speculation:
- Hedging: Managing risk arising from another exposure.
- Speculation: Taking exposure to benefit from an expected price movement.
The same derivative can serve either purpose. Buying an option does not automatically make a transaction a hedge.
Types of hedging
Hedges can be grouped by the financial risk they address:
| Type | Exposure being managed | Example of an approach |
| Equity hedging | Changes in share or portfolio value | Buying matching puts or selling suitable index futures |
| Currency hedging | Changes in exchange rates | Using a permitted currency forward or option |
| Interest-rate hedging | Changes in borrowing costs or rate-sensitive investments | Using an appropriate swap or interest-rate derivative |
| Commodity hedging | Changes in purchase costs or sale prices | Buying or selling suitable commodity futures |
These categories describe the exposure, rather than a fixed set of strategies.
Long and short hedges
In futures markets, the hedge’s direction depends on what needs protection:
- Long hedge: Buying futures to manage the risk that a future purchase becomes more expensive.
- Short hedge: Selling futures to manage the risk of falling prices affecting a holding or future sale.
Someone planning a purchase faces a different risk from someone who already owns an asset.
Instruments used for hedging
Many strategies use derivatives, whose values depend on an underlying asset, rate, index or other reference.
- Futures: Standardised exchange-traded contracts that create obligations to buy or sell under specified terms.
- Forwards: Contracts agreed between counterparties for a transaction at a specified future date and price or rate.
- Options: Give the buyer a right, without the obligation to exercise, in exchange for a premium.
- Swaps: Exchange agreed payment streams, such as fixed and floating interest payments.
A put option gives its buyer the right to sell under the contract’s terms; a call gives the right to buy. Selling an option creates obligations, which differ from the buyer’s rights.
Common hedging strategies
The strategy should follow the exposure you want to manage:
Protective put
A protective put combines ownership of an asset with a purchased put option on that asset. For matching share and option quantities, the strike price establishes a floor for the combined position’s value at expiry, before deducting the premium and other costs. You retain participation in rising share prices, although the premium reduces your net result.
Futures hedge
An equity investor can sell suitable futures to offset some exposure to falling prices. For a portfolio, the hedge needs to reflect how closely its holdings move with the chosen index. Equal rupee values alone do not establish a precise match. If the market rises, losses on the short futures position can offset gains in the holdings.
Collar
A collar combines a holding with a purchased put and a sold call, generally on the same underlying with the same expiry. The call premium helps offset the put’s cost. In return, the sold call limits gains above its strike price. The investor accepts a ceiling on gains in exchange for protection through the put.
Put spread hedge
A put spread involves buying a put and selling another put on the same underlying, with the same expiry but a lower strike. The premium received reduces the initial cost. However, the spread’s payoff stops increasing below the lower strike. Alongside a shareholding, it provides limited protection, with losses continuing if the share price falls further.
Sources: OCC’s Options Industry Council, protective put, collar and bear put spread guidance; CME Group, equity index futures hedging guidance.
Example of hedging with a put option
Consider a hypothetical share bought for ₹100 and a matching put option with:
- Strike price: ₹95
- Premium paid: ₹3 per share
At expiry, the put’s payoff per share is the higher of ₹95 minus the share price, or zero.
| Share price at expiry | Result without the put | Put payoff | Combined result after the premium |
| ₹ 70 | ₹30 loss | ₹ 25 | ₹8 loss |
| ₹ 100 | No gain or loss | ₹ 0 | ₹3 loss |
| ₹ 120 | ₹20 gain | ₹ 0 | ₹17 gain |
At ₹70, the put offsets ₹25 of the share’s ₹30 loss. After the ₹3 premium, the combined loss is ₹8. If the share price stays unchanged, the premium is a cost without an expiry payoff. If the price rises, you participate in the gain after deducting that cost.
The calculations show outcomes per share, assume matching coverage and exclude other costs and taxes. Actual contracts have specified lot sizes and settlement requirements.
Source: OCC’s Options Industry Council, Protective Put (Married Put), payoff principles; the figures above are hypothetical calculations.
Advantages of hedging
Depending on the strategy and exposure, hedging can help you:
- Reduce selected price risks: An offsetting position can lessen the effect of an unfavourable market movement.
- Plan future costs: A suitable currency or commodity hedge can make payment amounts more predictable.
- Retain a holding while adjusting exposure: Protection can address a particular risk without immediately selling the investment.
- Define protection for a period: A matching option can establish a contractual floor during the relevant term.
The value of these benefits depends on the hedge’s cost and fit with your financial needs.
Hedging vs diversification
Diversification spreads investments across holdings or asset categories. A targeted hedge addresses a particular exposure through an offsetting position or contract.
Owning several shares can reduce dependence on one company. An appropriate index derivative can instead reduce exposure to a broad market movement.
Diversification does not create a contractual price floor, and different investments can still decline together. Reviewing your asset allocation can help establish how much exposure fits your goals before considering a separate hedge.
Costs and limitations of hedging
These trade-offs help you assess the investment and hedge together:
- Premiums and fees: Protection can reduce returns even when the original investment performs well.
- Limits on gains: Futures hedges and collars can offset or restrict favourable price movements.
- Matching risk: The holding and hedging instrument may move differently, leaving some exposure unprotected.
- Cash requirements: Futures and sold options can involve margin obligations, while futures also have daily settlement requirements.
- Time limits: The hedge may expire before the exposure ends, requiring a decision about replacement.
- Liquidity and counterparty considerations: Closing the position and receiving contractual payments depend on the instrument and arrangement.
A loss on the hedge alone does not necessarily mean it failed. It may be the expected offset to a favourable movement in the original exposure.
Sources: NSE, equity derivatives margin and settlement guidance; Commodity Futures Trading Commission, Futures Glossary, basis risk.
What to check before choosing a hedge
Start with the specific exposure you want to reduce, then compare:
- Underlying match: Does the contract track the asset, currency or rate affecting you?
- Hedge size: How much exposure does each contract cover?
- Duration: Does protection last for the period you need?
- Complete cost: Include premiums, spreads, fees and replacement costs.
- Payment obligations: Understand margin, settlement and exercise requirements.
- Exit arrangements: Check expiry, delivery and early-close conditions.
- Eligibility: Confirm that the product, purpose and investment route are permitted.
In India, exchange-traded contracts have specified terms. Foreign exchange hedging also follows Reserve Bank of India (RBI) and Foreign Exchange Management Act requirements, including product and exposure conditions.
Review the hedge when the underlying holding or commitment changes.
Sources: NSE, equity derivatives contract specifications; RBI, Master Direction on Risk Management and Inter-Bank Dealings.
What are hedge funds?
Hedge funds are pooled investment vehicles that may use varied strategies, including derivatives, short positions and leverage. Hedging is an activity; a hedge fund is an investment vehicle. Its name does not mean every position is protected or that returns are assured.
In India, SEBI’s Alternative Investment Funds Regulations include hedge funds within the explanation of Category III AIFs. These funds employ diverse or complex trading strategies and may use leverage under the applicable framework.
Source: SEBI, Alternative Investment Funds Regulations, 2012, amended up to 14 July 2026.
Conclusion
Understanding hedging starts with identifying the exposure you want to manage. Options, futures, forwards and swaps offer different ways to address it, each with its own costs and obligations. Compare the protection, size and duration, then assess the original investment and hedge together to decide whether the strategy fits your plans.
FAQs
Which hedging strategy is best?
There is no single best strategy for every exposure. The appropriate choice depends on what you hold, how long you need protection, its cost and the payment obligations you can manage.
Can I hedge only part of my investment?
Yes. A partial hedge covers a chosen portion of the exposure, leaving the remainder subject to market movements. Contract sizes and the relationship between the hedge and your holding affect the coverage you can achieve.
Does a covered call offer the same protection as a protective put?
No. A covered call involves selling a call against shares you hold. Its premium provides a limited cushion and the call restricts gains, but it does not establish the downside floor provided by a matching protective put.
Is a stop-loss order the same as a hedge?
No. A stop-loss activates an order when the relevant price reaches a specified trigger. A hedge creates an offsetting exposure while the original position may remain open. Triggering and executing an order are separate stages, so its terms and available market prices matter.
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