chrismallee - a short answer is that hedging is about offsetting risk. An example would be if (say) you have a portfolio of UK shares and you fear a downturn in the market, but for whatever reason you don't want to sell you can hedge the risk. You could do this by buying put options which will increase in value as the market falls, offsetting the losses on the shares. If the market rises you profit from the increase in the share values, but lose the put premium which you should regard as an insurance premium. You could pay for the puts by selling calls above the market so that the downside protection could be placed for nothing. But given that you never get anything for nothing, you will not participate in gains above the strike price of the calls you have sold. This arrangement is known as a cap and collar.
There are many other ways to hedge using offsetting positions, normally based on futures or options.
Thanks Roger, I started replying and had written about as much as you, when I thought oh b*^%+(ks, I'll try a search. I think maybe I was in danger of complicating things. Better someone has a read up and then comes back :cheesy:
Hedging may be about offsetting risk, but without risk it is impossible to profit. It just gives me the oportunity to quote one of my favourite quotes - that the only place you will find a perfect hedge, is in a Japanese garden.