WHAT IS HEDGING IN FOREX MARKET
WHAT IS HEDGING ?
As we know that, not only in foreign exchange but hedging is a term we can hear in each and every financial market.
Hence,
Each and every trader should be familiar with this term. In basic words, hedging in Forex is a strategy to protect one's position in a currency pair from an adverse move. One is to place a hedge by taking the position in the same currency pair and the second approaches to buy Forex options.
IMPORTANT POINTS IN HEDGING
a) Process of protecting a position in a currency pair on the risk of losses is called hedging.
b) Hedging is done by two main strategies in Forex.
c) First strategy is to take position opposite in the same currency pair.
d) The second strategy involves using options.
e) In foreign exchange, hedging is a type of short term protection.
SPECIAL CONSIDERATION IN HEDGING
A trader tries to coming up with a way to protect against a big loss in foreign exchange. Two main strategies by which one can protect themselves from losses that is:
1) PERFECT HEDGE STRATEGIES
A Forex trader can create a "hedge" to fully protect an existing position from an undesirable move in the currency pair by holding both, a short and a long position simultaneously on the same currency pair.
Hence,
It is called 'Perfect hedge' as it eliminates all the risks.
2) IMPERFECT HEDGE STRATEGY
The forex trader can create " hedge" to partially protect an existing position from an undesirable move in the currency pair using Forex options.
Therefore,
This strategy is referred to as an 'imperfect Hedge' , because the resulting position usually eliminates only some of the risk associated with the trade.
UNDERSTANDING HEGING WITH EXAMPLE
Suppose, a trader short GBP / USD at 1.4225 thinking the pair is going to move lower but is also concerned the currency pair may move higher if the upcoming parliamentary vote turns out to be bullish.
Therefore,
Trader can hedge a portion of risk by buying a call option contact with a strike price somewhere above the current exchange rate like 1.4275, and an expiration date sometimes after the scheduled vote.
Hence,
If even after vote, the GBP / USD doesn't move higher the trader can hold onto the short GBP / USD trade, making profit the lower it goes.
Or,
If even after vote the GBP / USD starts moving higher, the trader does not need to worry about the bullish move because, thanks to the call option.
Therefore,
The risk is limited to the distance between the value of pair when options were bought and the strike price of the option, or 50 pips in this instance ( 1.4275 - 1.4225 = 0.0050 ), plus the premium paid for the options contract.
WINDING UP "HEDGING"
Hedging means coming up with a way to protect yourself against a big loss. When you buy a car insurance you are protecting, or hedging against the chance of having an expensive accident.
Apparently,
In Forex, think of a hedge as getting insurance on your trade. Hedging is a way to reduce or cover the amount of loss you would incur if something unexpected happens.
