Hedging is financial insurance — you pay a small cost now to protect against a big loss later. If you own stocks and worry about a market crash, you buy put options as a hedge. If the market drops, your put options gain value, offsetting stock losses. You sacrifice some upside for downside protection.
Common hedging tools: options (puts and calls), futures contracts, forward contracts, and swaps. Airlines hedge jet fuel prices — Southwest Airlines saved $3.5 billion between 1999-2008 by locking in fuel prices with derivatives. Companies like Starbucks hedge coffee bean prices; gold miners hedge gold prices.
A perfect hedge eliminates all risk but also eliminates all extra profit. Most companies aim for partial hedging — reducing risk to acceptable levels while retaining some upside. JPMorgan's infamous "London Whale" trade in 2012 was supposed to be a hedge but turned into a $6.2 billion loss — proving that hedging itself can go spectacularly wrong.