Suppose you have a position in a cash market which you want to maintain for whatever reason it may be difficult to sell, or perhaps it forms part of your long term portfolio. However, you anticipate an adverse movement in its price. With a derivatives hedge it is possible to protect these assets from the fall in value you fear. Lets see how.
As we have already said, the value of a derivative contract is related to the value of the underlying asset it relates to. Because of this, with derivatives, it is possible to establish a position (with the same exposure in terms of the value of the contract), which will fluctuate in value almost in parallel with an equivalent underlying position.
It is also possible with derivative contracts to go either long or short; in other words you can take an opposite position to the position you have in a particular underlying asset (or portfolio).
Hedging involves taking a temporary position in a derivatives contract(s), which is equal and opposite to your cash market position in order to protect the cash position against loss due to price fluctuations. As the price moves, loss is made on the underlying, whilst profit is made on the derivative position, the two cancelling each other out.
Protecting assets which you hold from a fall in value by selling an equivalent number of derivative contracts, is known as a short hedge.
A long hedge, on the other hand, involves buying derivatives as a temporary substitute for buying the underlying at some future point. This is to lock in a buying price. In other words, you are protecting yourself against an increase in the underlying price between now and when you buy in the future.
Cash and derivatives markets move together more or less in parallel, but not always at the same time, or to the same extent. This introduces a certain amount of what is called hedge inefficiency, which may need to be adjusted. At other times, an imperfect hedge might be knowingly established, which leaves a small exposure to the underlying market depending on the risk appetite of the individual.
Derivatives trading, as opposed to hedging, means buying and selling a derivatives instrument in its own right, without, that is, a transaction in the underlying. For instance, a trader can get exposure to the US government bond market by buying and selling US government bond futures without ever dealing in the actual bonds themselves.
The aim when trading derivative contracts is profit, not protection.