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Hedging is the practice of taking a position in the market to reduce the risk of adverse price movements. Derivatives (forwards, futures, options, etc.) are particularly suitable for hedging purposes.

Suppose a miner calculates how many bitcoins he will be able to mine in one month time given the inputs he has (hardware, electricity, labour, etc.). At the current BTC price, he will be able to cover the costs, but he cannot know the price in one month time. If the price drops low enough, he will not be able to cover the costs of mining.

To hedge this risk, the miner can use a futures market. He can enter a short position, agreeing to sell coins at a particular price in one month. If at that time the price will be higher than at the time of entry into the contract, the gains from selling coins at a higher price will offset the losses from a short position. However, if the price will be lower, the short position will offset the losses too.

The net result is that the miner knows precisely how much money he will receive in one month. It doesn’t matter if the hedge turns out to be positive or negative; the sole purpose of the hedge is to reduce the risk as much as possible.

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