Hedge is an investment or a trade aimed to reduce the risk of an adverse price movement of an asset.

Speaking generally, the term is applicable not only in the financial markets but in daily life as well. For example, when you are buying fire insurance for a house, you are hedging against potential fire damages your house might incur. Or, when your friend takes one position in an argument and then also defends the other - he is hedging.

In trading, the goal of hedging is to reduce a trader’s exposure to risks. This can be accomplished in a number of ways. The key is that the loss from the adverse price movement of an asset would be compensated by the gain generated by the same price movement.

Since derivatives in general and CFDs, in particular, expose a trader to the price movements of an underlying asset without actually owning that asset, they are a great instrument for hedging.

For example, you bought 5 Bitcoins as a strategic investment in hopes that their market price will go up. But you are uncomfortable with the significant BTC price swings that the industry news brings. You do not want to find yourself in a situation where your investment loses a big portion of its value just because some politician in a remote country has criticized the blockchain industry.

You decide to establish a hedge that would compensate for your losses whenever the price of Bitcoin goes down. You can do that by opening the Short (SELL) position with CFDs. Since a short position is a bet that the price goes down, the price decrease will represent your profit. I.e. what you lose in your 5 Bitcoins value you will gain with your CFD Short position.

Important, however, is that if the price of Bitcoin starts raising, increasing the value of your 5 Bitcoins, you will also incur losses on your Short CFD position. That means, while you are protected from the downside, you will not capture the upside. That’s the price of hedging!

Understanding hedge and how it works is extremely important and adds a serious tool to your risk management strategies.