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What is hedging? How traders offset market exposure

Understand offsetting market exposure through worked examples, including basis risk, funding, collateral, and the limits of an imperfect hedge.

By N1Oct 11, 20264 min read

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Hedging means taking an offsetting position to reduce a specified risk in an exposure you already have or expect to have. A hedge can change the combined outcome when prices move, but it also introduces costs and may leave important risks unaddressed.

The starting point is identifying the exposure: what changes in value, which price affects it, how much is exposed, and for how long. A trade described as a hedge is not automatically a good match for that exposure.

A hedge responds to an existing risk

An owner exposed to a falling price might use a position that gains when the matching price falls. Someone expecting to buy an input later might use a position that gains when that input's price rises. The appropriate direction depends on the original risk.

Reducing sensitivity to a price can also reduce gains from a favorable move. The hedge changes the combined exposure, and its costs affect the result.

A simplified matched example

Assume an illustrative owner holds one unit worth $100 and opens a short linear derivative representing one identical unit at $100. Ignore fees, funding, taxes, collateral changes, and differences between cash and derivative prices.

If both prices fall to $80, the owned unit loses $20 in value while the short has a $20 trading gain. If both rise to $120, the owned unit gains $20 while the short has a $20 trading loss. In this idealized example, the changes offset.

In practice, contract sizes, different price movements, and costs affect the offset. A gain on one position may also be unrealized or unavailable when the other position needs cash.

Basis risk: the hedge and exposure can diverge

Basis risk is the risk that the original exposure and hedging instrument do not move together as expected. A different asset, basket, delivery location, timing, or contract structure can create that mismatch.

Consider an illustrative collection initially valued at $1,000 and a $1,000 short exposure to a card index. The collection later falls 5%, a $50 decline, while the index rises 3%, creating a $30 short loss before costs. The combined change is minus $80. Matching starting dollar amounts did not create matching price behavior.

An arbitrary Pokémon collection and TCGX are not interchangeable. TCGX includes selected variants from four games under particular weights and rules. A short in that market is not a precise hedge for every collection—or even every included card.

Margin and liquidity risk remain

A derivative hedge needs collateral and can incur trading losses on its own leg. A favorable change in the asset being hedged may not generate available cash to meet those requirements. If the hedge is liquidated or closed early, the intended offset may stop working.

For example, an owned asset can rise while its offsetting short loses value. If the owned asset has not been sold, the gain may remain unrealized while the short still needs sufficient margin. Combined economic reasoning does not override the account's liquidation rules.

Perpetuals also have funding, while execution may involve spread, slippage, and fees. Closing the two sides at different times introduces another mismatch. Read funding rates, how liquidation works, and trade costs.

Partial hedges and sizing

A hedge can cover part of an exposure rather than all of it. A hypothetical one-half-size offset leaves some sensitivity to the original price, even under perfect matching assumptions. Using too much offsetting exposure can reverse the overall direction instead of merely reducing it.

Contract multipliers, currency, price relationships, and time horizon all matter. “Use the same dollar amount” is not a universal sizing rule, especially for a basket compared with one asset. Position sizing explains notional exposure and collateral as separate quantities.

Common questions

Is every short position a hedge?

No. Without an offsetting exposure or obligation, a short is a directional position. The purpose and relationship to the original risk determine whether it functions as a hedge.