Forex Hedging for Safety

Like the stock market, the forex market also involves risks and strategies to cover them using a backup plan. One such strategy that is widely practiced in both the markets is ‘hedging’. Forex hedging enables you to mitigate risk in forex trading. Anyone who is planning to invest should know what hedging is and how s/he can take advantage of it. Hedging as defined by some people is similar to purchasing an insurance policy for one’s currency position. This is done by using investment instruments called derivatives. These enable forex traders to not have to worry, as their losses will be covered.

Forex Hedging: How it is Done

One common way of hedging that is widely practiced is to open both long and short positions in one currency pair at the same time. Some dealers however do not allow this. Typically, businesses that operate at the international level practice this form of hedging. If a company in the UK serves a huge customer base in the US, then a weakening dollar against the British pound (GBP) is unhealthy for that company in the long run. This is because the original price quoted in US dollars would not get converted to as many pounds in the future. However, the company can overcome this situation by opting for a long position in GBP using US dollars as this would make up for the lost money. In the same way, if it loses money in the forex market in case the value of the GBP falls, it can counter the effect by earning profits due to the increased value of the US dollars it earns by selling its products. Such a type of hedging can be practiced by investing in futures contracts or options.

A futures contract is an agreement according to which one currency is exchanged for another at a predefined date in the future at the price that prevailed on the date of closing. Traders buy and sell currency futures as they do trade stocks. Currency futures are an excellent measure to hedge against volatile currency exchange rates.

Forex Hedging: Is there any Downside To it?

Many retail traders swear by hedging whereas others do not find any sense in it. The debate is ongoing regarding whether or not to practice hedging. Hedging comes at a price so make sure that the benefits you obtain from hedging are worth your while. Hedging only provides protection. It does not earn you big profits. It does not eliminate the risk but only reduces it. Traders have to pay for the hedge even when nothing goes against them.