Hedging in Forex is the most powerful tool for risk management and portfolio diversification used by traders, investors, and business organizations.
The currency’s value increases or decreases in the foreign exchange market because of many political, economical, social, and technical factors.
Due to continuous changes in currencies’value, individuals and organizations dealing in these currencies are affected by market risk. Therefore they use hedging to manage their risk.
What is Hedging?
A quick glance
Hedging is offsetting trade positions in opposite and correlated financial assets to deal with continuous price fluctuations and manage potential losses.
- Simple hedging
- Multiple Hedging
- Option Hedging
Using hedging does not eliminate the risk entirely. However, it can reduce the number of losses, and the chances of making profit increases.
Hedging is legitimate or not depends on the country you are trading. In some countries, it is legal, while in some, it is illegal.
Hedging forex example
Let us understand currency hedging cost calculation with an example. Suppose a company based in Canada has a contract to buy raw material from the United States worth 10 000 Dollars after one month.
According to the present currency exchange rate, 1 USD = 1.34 CAD. In this case, if the value of USD will further increase against CAD, then you have to pay more.
The company can use a currency hedging strategy to manage your purchase in this case. It can open a short position of CAD/USD for 10,000 US Dollars.
So, if the price of CAD increase or decrease against USD, it will not affect your purchase as you have already hedged the risk.
Strategies of hedging in Forex
You can hedge the risk of currency trading in the market in several ways. Here are some major hedging strategies with distinct features to choose the best suit your needs.
Simple hedging: It is the most common type of hedging in Forex, widely used by traders. The method suits beginners in trading as you can execute the strategy with basic knowledge.
Under this process, a trader opens the opposite trade to the existing one and hedges the risk. Suppose a trader has a long position in EUR/USD and thinks he may suffer a loss from the trade.
In this case, he can open a short position in EUR/USD, even if the price moves against him in the first trade. He will adjust it from the profit from the second trade.
Multiple Hedging: As the name suggests, it is the process of placing several trades in correlated and interdependent currency pairs. Correlations mean when the price of one currency pair affects the other.
When there is a favorable correlation price of pairs is expected to move in the same direction, and in case of negative correlation price moves in the opposite direction.
Traders, to decrease their losses and increase the amount of profit, take advantage of such currency pairs correlations. There is a negative correlation between EUR/USD and USD/CHF.
In the above case, suppose a trader has a long open position of EUR/USD and now he thinks his prediction may go wrong. So he can go short in EUR/USD.
Option Hedging: An option contract is a popular order type that gives right to buy or sell the asset at a predefined time and rate without obligation. It is the popular way to minimize your risk.
Let us understand option hedging with an example. Suppose you have a long position in CAD/EUR. In this case, you can buy a option to sell the pair, so if the market moves against you, the option contract can offset your losses.
Benefits of Hedging in Forex
Risk management: The first and foremost advantage of hedging is it plays a crucial role in managing risk. Like any other financial trading; currency trading also involves significant risk.
A currency pair’s price frequently changes due to changes in market conditions. Also, even after implementing the best trading strategy, profit is not guaranteed, and one may suffer losses.
Using hedging does not eliminate the risk entirely. However, it can reduce the losses.
Diversified investment: Hedging is a popular way to diversify your investment and invest in different assets. Generally, advanced traders diversify their investments and put money in various markets, such as stocks and commodities.
The main aim of diversifying investment is to adjust your loss from the profit of other assets. So, during inflation and other market uncertainties, it will help you maintain a profitable state.
Protecting your capital: Maintaining your account balance to avoid margin calls is a must for traders. Trading inconsistently without even considering your capital may have adverse results.
Forex Hedging helps you in preserving your investment capital during unfavorable market conditions.
Limitations of Hedging in Forex
Complex process: The process is more complicated than it looks; it requires analytical skills and an understanding of the market. If the strategy is not implemented correctly, it may affect the overall results.
Remember practical understanding of the concept of hedging, financial asset correlations, and dependency is a must. It may be a challenging process for beginners or traders with a lack of market knowledge.
Affect your profit: You must pay extra spreads, commissions, or fees to execute hedging strategies, so you have to adjust these costs from your overall profit.
Also, your profit depends on the amount of risk you are taking. When you try to reduce the risk, it will also affect the gain. In short, it will reduce the chances of making high profits.
Overhedging: No doubt, hedging is a great way to limit your losses. However, some traders start overhedging to minimize as much risk as possible. The process became more complex, expensive, and challenging in such cases.
Remember, balance, discipline, and patience are must for effectively using any strategy. If a trader hedges without adequately planning the trade, it may have severe outcomes.
Restrictions: Hedging is legitimate or not is depends on the country you are trading. In some countries, it is legal, while in some, it is illegal. In countries where hedging is legal, there are some rules and regulations, such as limitations on transaction amount, documentation, etc.
Also, US Foreign exchange brokers do not provide the facility of hedging to the traders. However, a broker from Asia and Europe allows traders to hedge their risk.
Hedging in Forex is a great way to make money in the forex market by efficiently managing the risk and limiting the losses. However, like any other strategy, it also has certain limitations.
The process will affect your profit and increase your trading fees, and if ineffectively implemented, the overall result may be unaffected. It is better to consider a price action plan to hedge in an appropriate manner.