Hedging is a strategy used by traders to protect their trading positions from adverse movements in the forex market. It is the process of buying and selling the same financial instrument to balance or offset the current position from risk exposure. Forex hedging as a trading strategy can be used in a wide variety of ways; simple, complex, or even futures. It depends on a trader’s experience and market knowledge.
The first strategy type is called a perfect hedge. In this case, traders open a long and short position on the same currency pair at the same time. This strategy allows you to open a reverse position for a currency pair without actually closing the initial position. For instance, if you buy USD/EUR currency pair then at the same time you can place a trade to sell the pair too. It is called a perfect hedge because you’re eliminating the whole risk. While the net profit when both the trades are open is also zero, you could make money from the position if you time the market right without sustaining additional risk.
Another common hedging strategy is a complex one using multiple currency pairs. A forex trader can hedge against a particular currency using two different currency pairs at once. If you’re buying USD/GBP, then you also open a short position of GBP/EUR simultaneously. Thus you would be hedging against the risk exposure of GBP. But this isn’t a perfect hedge as the price fluctuations of EUR and USD are also pertinent to your trade. This strategy helps experienced traders come up with a complicated hedge with multiple currency pairs to eliminate the risk exposure.
The third and final hedging strategy is using forex options. This is also an imperfect hedge as it doesn’t completely remove the risks involved in the trade. A forex option is an agreement to conduct a certain currency trade at a specific price in the future. For example, if you’re buying a long position of EUR/USD at 1.33, then you place a forex option at 1.32 to reduce the risk if the market moves lower.
Socio-economic and political factors make the foreign exchange market a highly volatile place. That’s why having a hedging strategy in place to diminish the risks from the sudden price movements can certainly help. Only if you have the timings and necessary market knowledge to pull it off. So try out the strategies with a practice account before risking money.
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