What is Forex Hedging and How Do I Use It?

What is Forex Hedging and How Do I Use It?

Whether you are a large corporation or just an individual trader, you should strive to understand hedging. Hedging is performed through the use of market instruments that are able to offset the risk of any negative movement in price.

You will discover that hedging is a little mysterious although it is a popular trading term in many quarters. You should consider it as a type of insurance plan. This is because you are insuring yourself against unforeseen events occurring when you hedge your Forex trades.

However, you must realize that if a negative event does occur, then your Forex trades could still be affected to some degree or other. You just will not take such a big hit if you have properly hedge your Forex positions. In other words, you have taken out the equivalent of a common type of insurance in case the worse happens.

You will discover that this is easiest done by hedging an investment against a similar one. For instance, most Forex traders achieve this goal by using ‘correlation’ and offsetting one currency pair against another suitable one.

For instance, if you decide to buy the EUR/USD, you will no doubt place a stop in order to safeguard your account. However, you can still provide additional protection by opening a sell position in the EUR/JPY. Hence, should the Euro fall unexpectedly and not as planned, then at least the drop in EUR/JPY could provide you with some compensation.

However, before charging in and utilizing this more sophisticated method of placing a stop, you should realize the following pitfall.

Basically, in this example, you would have opened a position in the EUR/USD and sell one in the EUR/JPY in order to cover the up and down movements of the Euro. However, you still would not be covering the situation if the USD rose against the EUR whilst the EUR climbed against the JPY.

To overcome this problem, you will have to open a third position and buy the USD/JPY. Your three trades will now cover every combination of buying and selling of the three currencies.

As you can image, this position can become quite complex and is one of the downsides to using currency correlation as a method of hedging.

Consequently, you will have to ensure that the benefits you get from hedging should be worth your time and effort. You will also have to evaluate that your financial outlay to cover your hedging is done in such a way as to provide you with a sufficient reduction in your Forex risk exposure.

You must always remember that you are using hedging as a method to protect your losses and it is not designed to produce for you large profits. Although your losses cannot be fully avoided, your hedging should dampen any negative impacts. In addition, you must realize that correlated hedging can invoke costs for you even though it may not be activated.

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