Hedging is known as a way to protect oneself against a big loss. Hedging is a kind of insurance on your trade. It is a way by which you reduce the loss you would incur if an unexpected, unwanted move would happen in the future. Forex hedge is a transaction made to protect a position or a future position from any adverse move in the exchange rates. It is important to note that a hedge is not a money making strategy.
Forex hedging is common type of financial transaction exercised by large international firms on a regular basis. This is done to mitigate the risks associated with exchange rate fluctuations. Hedging can be done in a number of ways within forex. This can be done by done primarily by engaging in spot contracts and currency futures and options. Companies and firms often gain unwanted exposure to foreign currencies, also to the volatile prices of raw materials, especially crude oil.
Foreign currency options are considered as the most popular method of currency hedging. This is because it gives the purchaser the right but not the obligation to buy or sell the currency pair at a particular exchange rate in the future.
Simple Forex Hedging
Some brokers allow a type of hedging known as direct hedging. Direct hedging is when you place a trade to fully protect an existing trade by holding both a short and a long position of the same currency pair. This type of hedging is also known as a perfect hedge as it eliminates all the risks associated with trade while your hedge is active. When you have both the positions open, your net profit would be zero. However, if you are able to timely tap into the market, you can make more money without exposing yourself to additional risk.
This trade setup may sound irrational to you as the two opposing positions cancel each other; it is highly common as you would think otherwise. Often, this is done when a trader holds a long position and wants to open a short term trade to gain from brief market volatility.
However, forex dealers in the Unites States do not allow simple forex hedging.
There are many types of complex hedging of forex trades. Most brokers in the United States do not allow the traders to take directly hedged positions in the same account; hence, other approaches become necessary. A forex trader may create a hedge to partially protect a position from an unwanted move in the currency pair. Using forex to protect a position is known as an imperfect hedge as only a part of the risk associated with the trade is eliminated.
Multiple Currency Pairs
In multiple currency pairs, as the name suggests, a forex trader trades in not one but two currency pairs. He hedges against a currency but through different pairs each of which contains the said currency. He can go long on JPY/USD and can go short on USD/EUR. In this type of hedging, it would not be exact but one would ultimately be hedging one’s USD exposure. There would however, remain an issue with this type of hedging; one would be exposed to unwanted fluctuations in the Japanese Yen (JPY) and the Euro (EUR). This is not considered as a reliable way of hedging unless you build a complicated hedge which would take into account the many currency pairs.
A forex option is essentially an agreement which is to be exercised in the future at a specified price. For example, one may want to have a long position on a currency pair of JPY/USD at 0.009. To protect one’s position against losses, one may place a strike option at 0.0088. This essentially means that if JPY/USD falls to 0.0088 in the specified time for one’s option, one would get paid out on the option. If JPY/USD does not reach that particular price in the specified time, one would lose only the purchase price of the said option. The farther away one’s option would be at the time of purchase from the market price, the bigger one’s payout would be if the price is hit within the specified time.
Reasons To Hedge
The word hedge implies to minimize your risk. It can be a bigger part of your trading plan if it is done after careful thinking. It should be left to be done only by traders who have a lot of experience and completely understand the market swings and timing. It can turn into a disaster for you and your account if you hedge without the required trading experience.
Hedging is a way to avoid risks in trading. However, it comes at a cost. There are transactional costs involved in hedging. In addition to this, hedging can dent your profit also. Hedging reduces your exposure if the markets move adversely. But, your profits will be diminished if the market moves in your favor.
One should always keep in mind that hedging is not a magic trick which guarantees you money irrespective of what the market does. It is also not a way to limit the potential damage of an adverse price fluctuation in the future.
Not all retail forex brokers in the Unites States allow for hedging on their platforms. One should research properly and extensively the market and the broker you use before beginning to trade.