What Is Forex Hedging?
When you buy a car, you want to protect yourself against the possibility of accidents and substantial financial losses. It is the reason people purchase auto insurance. In the Forex market, hedging is the equivalent of that but only for your trades.
The first example of financial hedging occurred in the 19th-century in agricultural futures markets. What does it look like now, and how can one use it properly? Let's analyze the ins and outs of hedging and what strategies you can implement to protect your funds from pricing fluctuations.
What Is Hedging and How Does It Work?
Hedging means investing in trades that will protect your funds from risky situations. Technically speaking, you would make offsetting trades in assets with negative correlations. It means that one asset decreases as the other increases, and vice versa. Put differently, one investment can be hedged by another trade in the opposite direction.
As we have said earlier, hedging works similarly to an insurance policy. However, it is not as easy as just renewing insurance once a year – it takes more skill and involvement to implement it in financial markets. But this method is an unspoken rule among different types of traders and investors. Individual traders, portfolio managers, and corporations all use hedging techniques to varying degrees.
Hedging is meant to reduce the risk of adverse price movements. Even though it can’t prevent feared events from happening, it prepares you to deal with the consequences better. The impact of an adverse event will be reduced, and your losses will be limited to a known amount.
What Is Hedging in Forex?
A Forex trader can create a “hedge” using a variety of methods. You can open a partial hedging position to diffuse the impact from negative market moves to some extent. Alternatively, you can carry out a complete hedge to fully mitigate your portfolio’s exposure to fluctuating prices. You can also use different financial instruments, such as futures or options.
An important thing to note about risk reduction with hedging is that it also implies a decrease in profits. Naturally, risk management is not free. This technique does not earn you money but instead minimizes your losses. If your initial investment makes money, you will lose on the other investment that you hedge with. And the other way around – if the second investment brings profit, the initial one loses.
For example, let’s imagine you have the following open positions:
You have not been planning to close these trades, but you are sensing possible fluctuations with the U.S. dollar because of certain political events. Instead of closing your existing trades, you take on an additional position – selling USD/GBP. It reduces your risk since you:
- Sell U.S. dollars to buy pounds
- Have a long USD trade and short GBP.
If you want to entirely remove your exposure to the dollar by selling two lots of GBP/USD. However, it would affect your exposure to GBP, which could turn out to be positive. Your decision depends on your risk tolerance.
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