What is Forex Hedging?
All right, let’s start with some basic definitions. First of all, what is hedging? Hedging is a way to limit risk by taking a trade in the opposite direction in a related asset or the same asset. So let’s say that you bought a stock, you could buy an option on the stock, which would make money if the price went down. So you would be long on the stock, but you would have that downside protection with the option. Or you could sell some of that same stock short in another account, and that would cover some of your downside risks also.
So that’s a way of limiting your risk and at the same time, taking advantage of the direction that you think that asset is going to go in. Now, this risk reduction might not be a total loss you could actually profit from it and that’s what we’ll talk about a lot in this article.
Types of Forex Hedging Strategy
From the above definition, you will deduce that we mentioned two types of forex hedging strategy, the first is buying an option on a stock you are already trading while the second is entering the opposite direction on the same commodity you are trading on. This means that there are mainly two ways or strategies in which a trader can trade using the forex hedging strategy.
The first is using or taking option or futures trade to hedge your financial position, this method is used mainly by large organizations, while the second hedging strategy is simply taking opposite trades on the same currency pair you are trading in.
This means taking a long and short position simultaneously on the same currency pair. This particular strategy is used mainly by retail traders and it’s easier to execute.
You should keep in mind while reading this article that forex hedging can actually be an advantage for you. Now, international companies use hedging to limit their foreign exchange risk. So take BMW, for example, they’re selling cars in different countries, and those currencies can fluctuate over time. So they want to protect themselves in case one currency gets too cheap or too expensive and they have a department that hedges their risk on the currency exchange. So that’s one way that big companies use hedging in their day-to-day operations.
Another area where companies use hedging to limit their risk is if they’re a large corporation that uses a lot of commodities, for example, gas or lumber or things like that, that could go up in price significantly. They’re going to hedge that so, for example, an airline would lose money if their fuel cost is too high. So they could use some futures or options to make some money if the price of fuel goes above their profitable price or even before that. That’s another way that big companies use hedging to limit their risk.
Finally, you may not know this, but hedge funds were founded on the principle that they’re going to be hedging their positions. So they were supposed to be slightly safer investments, but that’s no longer the case anymore. A hedge fund doesn’t have to hedge, but they were founded on that principle, and that’s why they’re called hedge funds. All right, now I’ve shown you how hedging works for big corporations and large hedge funds. But as I know you might already be asking, what about independent traders like us?
Well, retail forex provides an easy way to hedge without expensive options or futures contracts or complicated transactions. Another great thing about retail forex is that it can be easily traded, long or short. It’s the only market that the small independent trader can easily do this in and that’s why this article is targeted directly at retail forex traders. This is not for futures, not for stocks, not for crypto. This method will only work in the forex market and I believe it’s worth mentioning.
The transaction costs are so low that even if you have a small account, let’s say like $500, you can still do this without incurring a lot of transaction fees and a great benefit of hedging in forex is that you can get an excellent feel for the movements of a particular currency pair. So let’s say that you’re trading the pound dollar (GBPUSD), and since you don’t have to necessarily enter and exit the pound dollar at certain prices or with a certain system, you can kind of take some off here, take some off there, put some more on here.
You’ll get a really good feel for how the pair moves and that can help you with your hedging, but it can also help you in developing other trading systems in the future.
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