Hedging means reducing or controlling risks. It is carried out by opening a position in the futures market opposite to that opened in the physical market. Thus, adverse price changes in one market are offset by trade in another.
When performing hedging, a trader tries to fix prices at a certain level. Its purpose is to protect itself from adverse price changes. The futures market is filled with a huge number of speculators who constantly open positions based on price movements. In addition, arbitrage players also trade. They make a profit whenever they spot a price flaw. Together, however, they provide a stable link between the spot and futures markets, which makes it possible to engage in hedging. The easiest way to understand the principles of hedging is to consider a real-life example. Imagine that an automobile manufacturer purchases a huge amount of steel for its production. At the same time, he enters into an agreement with dealers for the supply of cars within three months. Thus, the contractual obligations were fixed at the time of signing the contract. The manufacturer is currently at risk in the form of rising steel prices. In order to hedge (insure) the price risk, he can buy a futures contract with a maturity of three months. It is now protected from fluctuating steel prices. If the price of steel rises, the prices of futures contracts that the manufacturer bought will also rise. Thus, he will profit from the futures trade. However, the manufacturer needs to buy steel to meet the needs of production, and in this situation, he faces a corresponding loss in the physical market. But this loss is offset by gains in the futures market. When buying steel in the physical market, an automobile manufacturer can balance its position by selling an open futures contract. If the price of steel falls, the prices of the futures contracts that the manufacturer bought will also fall. Thus, the futures trade will bring losses. The car manufacturer still needs steel from the physical market, in this case buying it leads to a strengthening of its position (due to the fall in steel prices). However, the corresponding fall in prices in the futures market levels out the gains received in the physical market. At the time of the purchase of steel in the physical market, the automotive manufacturer rebalances its position by selling an open futures contract. This kind of trading leads to perfect protection when prices go up or down. In addition, it provides additional benefits in the management of automotive raw materials.