What Is the Trade-off between Risk Reduction and Potential Profit When Hedging?

The fundamental trade-off when hedging is that reducing risk also means reducing potential profit. A hedge acts like an insurance policy; it protects against downside losses but this protection comes at a cost, which can be an explicit premium (for options) or an opportunity cost.

For example, if you hedge against a price drop and the price instead rises significantly, your gains will be limited or reduced compared to what they would have been without the hedge. The goal is to find a balance where the level of risk is acceptable, even if it means capping potential upside.