What is Forex Hedging?
Forex Hedging allows a currency trader to diminish or do away with the risk of foreign exchange. It is a sort of insurance to protect your portfolio against the malignant impact of negative forex market trends. Strategic use of hedging options allows for offsetting the risk of adverse price movements in a volatile market.
Forex Hedging is said to be invoked by a trader when he makes an entry into a currency trade with the explicit intention of having a current or anticipated position protected from any undesirable swing in the foreign currency exchange rates.
Strategic employment of hedge will save the trader from downside risk when he desires to go for a long position i.e. buys a currency pair with the expectation that the price will move up. In contrast, traders hoping for a short i.e. selling a currency pair in the anticipation that the pair’s price will see a fall can save themselves from upside risk.
In the retail trade, the prominent modes of hedging are spot contracts and foreign currency options. Spot contracts in essence are the customary trade executed by retail currency traders. Such contracts fail to prove themselves as effective hedging tools owing to the exceptionally short term delivery period of two business days.
In contrast, regularly indulging in spot contracts calls forth the necessity for protection through hedging and hence they cannot be termed as efficacious hedging vehicle.
Foreign currency options are indisputably the most preferred ways of forex hedging. This function in close similarity to options exercised for other security types. The option confers upon the purchaser the right, which is not obligatory, to purchase or sell the pair of foreign currency at a defined exchange rate at a particular period in the near future. The loss potential can also be limited by employing the customary options strategy like long strangles, long straddles and bear or bull spreads.
Judicious employment of hedging instruments with a penetrative insight can lead to development of trading strategies wherein loss suffered in one foreign currency trade can be offset by the gain pulled off in a derivative. Options and futures are two complicated hedging instruments known as derivatives.
Risks invariably will accompany investment although being precarious in nature. Fundamental knowledge of forex hedging strategies will help in developing the awareness of how to protect oneself against a volatile market and mitigate the consequences. Advancement in the understanding of market undercurrents will make one a better investor.
This is a post by Onlineforex.net, a site which gives information about online forex trading, brokers, currency trading, and much more.