The Forex (FX) or the Foreign Exchange Market deals with the buying and selling of currencies of different countries all across the globe. It is essential because we need to exchange currency for business and foreign trading to go on and to maintain a balance in the world economy. The Forex has no centralized location. It includes an electronic network of banks, brokers, institutions as well as individual brokers. They continuously keep tabs on the direction of currencies. They also post their orders of buying and selling in the network accordingly. The need to exchange currencies is what makes Forex the largest and most liquid financial market in the world. It has exchanges worth trillions of dollars happening every day, shadowing its competitors like the stock market. Open 24 hours a day, five days a week, the Forex market allows different options for trading currencies, one of the most profitable being hedging.
Traders of any financial market are always on the lookout for ways of limiting the risks. They want to improve their chances of maximum profit. While substantial and consistent benefits can be made in Forex trading environments, one almost always runs the risk of a loss. Hence, having an in-depth knowledge of the money markets along with well-thought and analyzed Forex trading strategies minimizes the risk to a great extent. Amongst numerous options of forex trading out there through governments and large companies, hedging is one of the most powerful trading strategies. Many large institutions have made hedging as mandatory for trading in Forex as it optimizes the chances of winning. Investment funds named after this strategy that ‘hedge’ most of their trades are generally known as ‘hedge funds.’
Hedging is similar to getting insurance to a trade. It is meant to eliminate any risk of loss during times of uncertainty and to protect you from any significant damage that may incur. It is a strategy that protects one’s trading position lest there be an adverse move in any currency pair and exchange rates. By trading hedges wisely, one who is long a foreign currency pair or expecting it in future can be protected from downside risk. Alternatively, a trader or investor who is short a currency pair can be protected against upside risk.
For Forex traders, there are usually few strategies to follow while hedging
- Simple or Direct Hedging: Direct hedging is when one is allowed to place a trade to buy a currency pair. It will enable the placing of a deal to sell it at the same time. Although one incurs zero profit while both trades are open, one stands a chance to make money without incurring any additional losses if the market is favorable. As a means of trader discretion, one can undoubtedly close the first trade and enter the market at a better price. But the beauty of hedging is that one can retain one’s first deal in its position while opening a second trade at a better spot. It brings profits as the market moves against the first position.
- Multiple Currency Pairs: In this type of trading, the forex trader uses two separate currency pairs to make a hedge against a particular currency. For example, one could go long EUR/USD and short USD/CAD. In this case, the only issue one would have to deal with was the fluctuations in the Euro and Canadian Dollar. It would imply that if the Euro becomes a stable currency against all other currencies, there could be a fluctuation in EUR/USD. USD/CAD would not counteract it. Hence this type of hedging is mostly avoided unless one is building a sophisticated hedge that takes many currency pairs into account.
- Currency Options: Just like trading options with stock as the underlying asset, currency options enables investors to participate in the foreign exchange market. It is an agreement that gives the buyer the right to buy or sell a particular currency at a specific exchange rate in the future. A premium has to be paid for this to the seller, depending on a variety of factors. Currency options are one of the most common ways for corporations, individual traders, or financial institutions to hedge against an adverse movement in currency exchange rates in the Forex.
Hedging is an excellent way for one to limit risks in Forex trading. If done carefully and strategically, it can also lead to consistent profits over some time. However, one must have enough experience in trading before venturing into hedging as well as have a strong understanding of the market statistics and analytics.