The US Commodity Futures Trading Commission (CFTC) describes a hedger as a market participant who takes positions opposite to those held in the cash market to minimise the risk of financial loss from an adverse price change. This glossary entry explains what hedging in trading means in plain terms, works through three examples with numbers, and covers the costs and traps that most short definitions leave out.
What is hedging in trading, in simple terms?
You hold something whose price can fall. You open a position that rises when that price falls. If the price does fall, the loss on the first position is partly or fully offset by the gain on the second. The trade-off is that if the price rises instead, the hedge loses and eats into the gain.
A hedge works like insurance: you give up some upside and pay a cost in exchange for a narrower range of outcomes.
Example 1: hedging physical gold with a short position
Assume a hypothetical gold price of $4,000 per ounce. An investor holds 10 ounces of physical gold worth $40,000, expects to sell it in a month, and worries about a fall before then.
They open a short position of 0.10 lot at a broker where 1 lot equals 100 ounces, which is 10 ounces of exposure.
| Gold one month later | Physical gold (10 oz) | Short 0.10 lot | Combined, before costs |
|---|---|---|---|
| $3,800 (down $200) | −$2,000 | +$2,000 | $0 |
| $4,200 (up $200) | +$2,000 | −$2,000 | $0 |
In both cases the hedge locked in roughly $4,000 per ounce. The investor is protected from the fall and has given up the rise. Then come the costs: the spread on opening and closing the short, overnight financing (swap) for every night the short is held, and any difference between the price of the physical gold and the broker's price. Physical prices also include dealer premiums that a CFD does not track. Our explainer on gold spot versus futures covers why two "gold prices" can differ.
Example 2: the "locking" hedge inside one trading account
Some traders open a buy and a sell on the same instrument in the same account when a trade goes wrong, and call it a hedge.
Example: long 1 lot of gold at $4,000. Price falls to $3,950, a $5,000 floating loss. Instead of closing, the trader opens a 1-lot short at $3,950.
Any further move now has zero net effect: the floating loss is frozen at $5,000. But the loss has not gone anywhere. The trader is paying two spreads, holding two positions that may each carry overnight financing, and still has to decide which side to close first and when. In practice this delays a decision rather than solving it. Closing the original trade at $3,950 gives the same net result at a lower cost.
Some brokers do not allow opposite positions in one account and net them instead, and margin rules for "hedged" positions vary. Check your account terms. If margin is a concern, our guide to margin calls explains how they are triggered.
Example 3: cross-hedging with a related market
A cross-hedge uses a different but related instrument, for example hedging a silver position with gold, or a currency exposure with a correlated pair. It works only as well as the correlation holds, and correlations change, especially in stressed markets. A correlation of 0.8 still allows the two markets to move apart on the very day you need protection. Our article on correlation and diversification explains why correlation is not a fixed number.
What does hedging actually cost?
| Cost | Where it comes from | How to estimate it |
|---|---|---|
| Spread | Opening and closing the hedge | Spread in price × ounces or units, on both legs |
| Overnight financing (swap) | Holding a leveraged position past the daily rollover | Your broker's swap rate × nights held |
| Basis difference | The hedge not moving exactly like what you hold | Compare the two prices over time |
| Opportunity cost | Giving up gains if price moves your way | The upside the hedge removes |
Our guide to what a spread is shows how to turn a quoted spread into a dollar cost. The longer a hedge stays open, the more these costs add up, which is why most hedges are meant to be temporary.
When does hedging make sense, and when does it not?
when you hold an asset you cannot or do not want to sell right now, the risk is specific and time-limited, and the cost of the hedge is smaller than the loss you are protecting against.
when it is a way to avoid admitting a losing trade, when you are not sure what exactly you are hedging against, or when a smaller position or a stop loss would do the same job at a lower cost.
The TIC angle: risk first, not cleverness
At TIC we treat hedging as a risk tool, not a way to make money. For most individual traders, position size and a predefined exit do more for risk than a hedge does. If you do hedge, record both legs and the reason in a trading journal, such as the free journal in the TIC app, so you can see afterwards what the hedge really cost and whether it protected anything.
Sources
- US Commodity Futures Trading Commission, CFTC Glossary (Hedger, Hedging)
Prices are hypothetical. Contract sizes, swap rates and rules on opposite positions vary by broker and product.
Trading carries high risk and you may lose your capital. Past performance does not guarantee future results. Educational only, not investment advice.
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