Hedging is a technique or process to mitigate risk, by entering into a futures contract or through any other means.
Let's understand how you can hedge through your risk in equity or any commodity through a Futures contract or a derivative instrument whose value is derived from an underlying asset.
In hedging, investor or speculators take an opposite position that have created in the spot market or physical market.
An investor comes in a contract and agree to transact a financial instrument or physical commodity of standardized quality and quantity at a particular price agreed upon today for delivery and payment at a defined future date.
Click to know the difference between Spot price and Futures price.
By doing this he is mitigating the risk by fixing the price of the commodity or financial instrument today. So, that if the price fall in the spot market he can recover the same from futures market( As he would have entered opposite position).
Hedging is mainly carried by commodity, capital market or importer or exportes, who hedge their risk by buying dollars or selling the same.
Let's give a simple example of equities. A buyer may be bullish on Canara Bank and might opt for taking delivery of the same in the cash market. Say, he hold 1000 shares of Canara Bank at Rs 411 in the cash market. At the same time he could sell Canara Bank February Futures for Rs 412.80. By creating a buy and sell he has hedged his risk. The only worry in the futures market is he would have to square up his position, while in the cash market he can hold the shares till he is alive.
The process of taking short positions or selling positions to mitigate downside risk is called short hedging. The process of buying long positions to avoid upside risk in the futures market is called long hedging. Click to know more on Long and Short Positions.