Forex Hedging Explained
In the Forex market, as a trader, you want to reduce your risk. This is where Forex hedging comes in as one valuable technique among many. Forex hedging means that you establish some type of “insurance” for yourself in case something negative should happen.
Forex hedging does not mean that you’re going to come out of a negative event like a loss completely unscathed, but it’s going to help you minimize the negative event as much as possible, so that you are as safe as possible; in other words, you’re going to experience “less” loss with hedging, if things go right.
What is hedging in Forex, exactly?
In one of the simplest hedging strategies in Forex, you hold the same currency pair (for example, the US dollar and the euro) and both long and short positions. Common wisdom has had it that in Forex, it’s important to learn hedging as a technique even if you never intend to use it simply because you can minimize your losses on risky trades.
Another form of hedging in the currency market is using derivatives such as future and options. Using for example a future contract the trader can protect himself from the constant fluctuation in prices by fixing the conversion rate for a future date.
Pros and cons of hedging
Hedging provides insurance for those times when you want to take a major risk as a means to cut losses, but remember that it may not work. Learning how to hedge will give you a better understanding of how the system works and therefore how to navigate it yourself, and that can make you a better and more skillful trader. However, remember that you NEVER have to hedge. It’s simply one technique you can use to minimize losses when you’re taking a particularly major risk.
Are there times when you shouldn’t hedge?
Absolutely; you can trade in Forex for your entire life and never once use hedging. Hedging is simply a way to try to minimize the risks involved. And of course, all of Forex trading involves at least some risk, but this is something you should know before you even begin. In addition, keep in mind that hedging is not going to guarantee protection from a major loss. You could still lose when you hedge and experience significant loss. Whether or not you hedge is entirely up to you.
The future of hedging in Forex
Hedging alternatives in Forex have become limited. As of May 15, 2009, it’s essentially become “illegal” to go long and short on the same pair at the same time; what your broker will simply do is to offset them against each other and give you no trade left open. Those who have had hedges established previous to May 15 can leave them open, but once these positions are closed up, you can’t reopen positions that will essentially be hedges.
In short, you never have to trade in Forex and use hedging as a technique. It’s a very good idea to learn hedging techniques so as to minimize risk, but it has become “illegal” and therefore largely obsolete as a technique anyway.
