Somebody explain hedging

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Hedging is primarily for risk management. For example I might run a matched book at a bank, making markets in any product, this means that for every trade I do for a client I will do an offsetting trade in order to offset the risk (you will still have counterparty risk). I make a profit by charging a higher bid offer on the client trade than on the hedge. The bank might not run matched, which would mean the trading desk has a view about their product, but they will still have risk limits meaning as you reach these limits you will need to hedge to offset it. This also happens at hedge funds/prop shops/quant firms. It’s easy to say “that sounds like pussy shit” when you’ve never lost real money because of bad risk management…

Outright price risk is often very dangerous for a PM. Every successful trader is playing spreads.

Futures example: I think the nat gas market is overvalued, so I do some analysis and find the most overvalued month, which I decide to be April 24. If I short April futures, and Pennsylvania shale fields get nuked tomorrow, not only are all the quakers dead, I also just lost my job because the nat gas market as a whole just ripped through the ceiling. If I was smart, I would have shorted April and gone long March. In this example I’m right about the fundamentals of April, April goes down, but March not so much, and I don’t give a shit about those Quakers because my losses from going short in April are offset by the gains from going long in March. This is why we hedge.

It allows you to eliminate risk. In perfect situation, you can hedge all risk and make pure profit (I.e., an arbitrage opportunity). For example, one street vendor sells a bunch of bananas for $1 whereas the guy down the street sells them for $1.10. You’d buy the $1 and sell them to the other guy for $1.10 - a riskless $0.10.

Obviously pure arbitrage is pretty rare with stuff like quant reading and doesn’t really exist for retail investors.

However, you could hedge other types of risk or volatility. If you think a specific banana company is really good but don’t want the risk of the entire banana industry, you could long one share of that company and short an equal weight of the banana industry. Much smarter people on their forum could probably explain better but hope this helps.

If you wanna look deeper into the academic side of hedging, look into the Greeks (delta neutral, gamma neutral, etc).

Good answers so far but think it might help simplify into a "real life" context.

You've doing this "pussy shit" your entire life.  For instance, when you're applying to universities, you aren't going to just apply to ivies.  No, you're going to hedge and apply to ones you think you have a good chance of getting into to make sure you're able to attend college.  Or for a recent example in your case, you aren't going to apply to only JPM/GS/MS, rather you're gonna apply to other banks to hedge.

I think the easiest way to look at it is through a commodities lens since that is where the concept comes from.

Say you buy 100,000 barrels of crude oil and it is sitting in a big tank in Midland, Texas. You bought it because you plan on selling it to an exporter in Corpus Christi next month. With crude currently at ~$80.00 that would cost you $8,000,000 to buy. If the price goes down between now and then you are stuck with all the losses. For example, if prices go down $2.50/bbl you just lost $250,000. Obviously, you could have also made $250,000 if prices had gone the other way too. But that is pretty risky to just expose yourself to massive losses/gains each month. It is only a matter of time before something really bad happens and you lose millions of dollars on your way to becoming insolvent. The way to reduce that flat price risk is through hedging. Instead of just owning that crude in Midland outright why not offset your long crude position with a short futures position? The futures contract you would use to hedge would be WTI that is based on delivery in Cushing, Oklahoma. Since you own physical barrels, and your risk is that prices decline, you would short the WTI futures contract so that way any decrease in price of your physical barrels would be offset by the money you made from shorting the WTI futures. The only risk you have now is the difference in price between Midland and Cushing. The difference in price between Midland and Cushing is not constant so there could be times when the value of crude in Midland goes down 20 cents but the futures go down 25. This would mean you make 5 cents more on your hedge than you lost on the physical barrels. It could also go the other way and you lost 5 cents more on your physical barrels than you make on the hedge. It is a much better risk scenario to potentially lose 5 cents over a month than 2.50.

Basically Rostov's post, just very simplified. 

You're an O&G producer.  You expect to produce 1mm bbl/yr.  Commodity prices are volatile, so you want to lock in prices to protect your downside.  WTI is currently $85 and you want to lock in prices in case it falls through the floor. 

You buy swaps (hedges) for 800k bbl/yr at WTI of $70

Scenario 1:  WTI falls to $50/bbl.  80% of your volume is locked in at the swap price of $70, and you realize the downside (market prices ) on the remaining 20% 

Scenario 2:  WTI rises to $100.  80% of your volume is locked in at the swap price of $70 and you realize the upside (market prices) on the remaining 20%

Any return above the risk free rate you get comes with an implied downside, aka risk. And for a trade the risk is often multi-dimensional. Hedging is just getting rid of the risks you don't want and keeping the risk you want, as well as the upside of that risk.