What is Hedging in Forex Trading?
Hedging is one of the most familiar trading strategies for the traders at the forex trading platforms. Basically, it tells a trader about the potential loss that can happen unexpectedly and warns regarding it.
In simple words, it keeps a trader aware of the adverse effects that may occur during trading. Following are one of the two ways to hedge a trading pair on Forex.
To avoid an unwanted move in the trading and to protect their current portfolio, a trader can create a hedge on forex. This process makes sure that the trading pairs of a trader remains safe from all sort of possible loss and can have chances of gaining profit. This way of hedging is mentioned as the perfect hedge.
This type of hedge is need when a trader holds both long or short currency pairs. This type of trade structure may sound a bit odd as the two-contrasting positions neutralize each other. It remains one of the most common ways to hedge trade at forex. As both long and short trading is being examined under this process, it often takes opens a short trade contrary to the long and takes advantage of the volatile market.
Surprising, this type of hedging is abandoned in the U.S. and the traders apply an alternative way of hedging as they make the contrasting trade as a close order which net outs both the positions. So, it provides a similar outcome as of the perfect hedged trade.
In order to eliminate any sort of risk that can end up in a loss, traders use Forex options. While using the Forex options to prevent any significant damage and secure both long and short positions. Such type of hedging strategy is mentioned as an imperfect hedge. Using this strategy it reduces the potential risk of loss to some extent, so that’s why it is known as the flawed way of hedging.
To understand an imperfect hedge, what a trader needs to is knows is that while implementing this hedging strategy a trader who holds a long currency pair can go with the ‘buy put option contracts’ which lowers the declining risk. While on the other side, a trader with a short trading pair has the option to ‘buy call options contract’ to lower down the inclining risk.
Imperfect Declining Risk Hedge
It is not obligatory, but traders have an alternative to put option contracts that allows a trader to sell a currency pair at a particular price and preset an expiry date to the options seller switching the for the payment before the amount that is set to be paid mentioned in the contract.
Through example, we can understand this in a better manner. For instance, a forex trader is long the USD/EUR at 1.2570 and is predicting the pair to move upward and is also worried about the bearish market.
In such circumstances, a trader can hedge a wedge of the risk by buying a put option contract with a specified price that must be low and near to the current exchange rate, such as 1.2545 and also determine an expiry date.
In case the market doesn’t go bearish and the price of the trading pair doesn’t go down, the trader can still hold the trading pair and have an opportunity to make greater profits from the bull market (high price). However, it costs a premium while paying for the put option contract.
In case if the market goes down and the trading pair follows a downward trend, here’s where a trader can be calm because of the limit of risk set up before buying the trading pair (1.2570 – 1.2545 = 0.0025), and also the premium that was paid for the options contract.
Imperfect Inclining Risk Hedge
Similar to the put options contract, the call options contract has the same strategy before buying any trading pair.
Now understanding this upside risk, let us consider an example. For instance, a trader is short the USD/GBP at 1.4220, predicting the pair to move downward, but has hope that it can go up in the upcoming bull run. In such circumstances, a trader can hedge a wedge of the risk by buying a call option contract with a specified price that must be above and near to the current exchange rate, such as 1.4270 and also determine an expiry date.
In case the market doesn’t go bullish, the trader can still hold the trading pair and have an opportunity to make higher profits as the price lowers down. And for all this, it just costed a premium while paying for the call option contract.
In case if the market goes up and the trading pair follows an upward trend, here’s where a trader can be calm because of the limit of risk set up before buying the trading pair (1.4220 – 1.4270 = 0.0050), and also the premium that was paid for the options contract.
Forex hedging is a great way to escape from trading risk. Many of the expert traders do not hedge as they feel that it is exciting to experience the volatility of the market. However, those who are new on the Forex trading platform and don’t know much about trading should go for Forex hedging that would make them more profit and with time they will be able to gain experience.