Hedging is actually an insurance for trader’s profit/losses against adverse market conditions. Technically, hedge trading can be defined as a process to eliminate the risk of erratic price fluctuations in the market.
Various hedging techniques can protect your stock against various types of risks. It protects your capital against fluctuation in prices due to change in demand and availability of various basic commodities such as metal, agricultural commodities, etc. It may help negate the risk faced due to overseas trading where change in currency causes discrepancies in stock value. The prices of stocks also change due to market dynamics causing the investors to lose money. This is referred as equity risk and hedging plays a vital role in protection against it. To negate equity risks, investors usually take the opposite positions in the futures.
Forward contract is also one of the most widely used methods to reduce the risk involved in trading. COD (contract for difference) is another well-known hedging method. This is a double edged method where the dealer and purchaser fix the price of the commodity and the difference of the agreed price and the actual price is paid to the one in loss. Generally, this method is not used due to the fact that the one in the profit takes a cut from his increased income.
The effectiveness of these methods are measured by their ability to reduce risks i.e. the best hedging method reduces risks to potentially zero percent. In all fairness, it reduces your profit but it also secures your position in market in return for a small investment which is totally worth it.