Hedge ratio
If you hold one asset against another, how much of the second do you need to cancel the risk?
In plain words
A hedge ratio is the amount of one position you hold per unit of another to offset its risk. Hedging one dollar of an asset with a closely related one usually means holding less than one dollar of it, scaled by how closely they move together and how much each one swings.
Why it matters
A ratio set too high leaves the hedge larger than the exposure it protects, so costs and losses on the hedge can outweigh what is being protected. A ratio set too low leaves part of the original risk running. Both errors grow with the size of the position.
In a real week: ETH, week of 19 April 2021
In the week of 19 April 2021, ETH and BTC had an hourly correlation of 0.9, ETH's realised volatility was 146.9% a year, and the ETH/BTC ratio changed by 18.78% while ETH beat BTC by 16.4 percentage points. A hedge sized one-for-one against BTC would have been heavier than this 0.9 relationship supports, and the 28.68% weekly range shows how quickly such a mismatch could cost.
A common mistake
Assuming a one-to-one hedge is correct. Two assets rarely move together perfectly or with equal swing, so a unit-for-unit match usually over-hedges or under-hedges.