Hedging Forex

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Learn Forex Trading / Currency Trading Tips

What Does Hedging Mean in the Forex Market?

Just like in the stock market, forex investors often use a strategy called hedging to decrease some of the risk associated with trading. Many people think of hedging as buying an insurance policy for their currency position, and it acts in much the same way. By using investment instruments known as derivatives, forex traders can rest easy knowing that any losses will be covered by the backup plan.

One type of derivative that many forex traders use to hedge a position is a futures contract, which is an agreement to exchange one currency for another at a specified date in the future at the price on the last closing date. Currency futures are bought and sold on a market just like any other instrument such as stocks or currencies, and are a great way to hedge against changing currency exchange rates. For example, say you used dollars to take a long position in euros, but you are a little worried that the price of euros will fall relative to the dollar. One thing you could do is take out a futures contract on dollars using euros. As external factors affect the price of currencies, the price of futures contracts rise and fall as well, allowing your euros-to-dollars contract to counteract your long position in euros. If the euro weakens, the futures contract price rises, and vice-versa, so you have therefore eliminated the risk from your currency investment.

Another form of hedging in the forex market that is practiced regularly is done by businesses that deal internationally. A company that has many customers in Europe may be concerned that a weakening euro would cost it money in the long run, as the original price quoted in euros wouldn’t translate into as many dollars going forward. By taking a long position in dollars using euros, the company would make just as much money in the forex market as it lost due to the fall in the euro’s value. Likewise, if it lost money in the forex market due to a fall in the value of the dollar, the company would make up for it in increased profits due to the greater value of the euros it is bringing in while selling its products. The position in the forex market has effectively neutralized any threat the company may have faced due to a weakening euro. This type of hedging can take several other forms, including futures contracts and options.

Traditional forex options are derivatives that allow the buyer to purchase an amount of currency from another trader for a set price, and make a great hedging tool. Again, these are instruments that are traded on the open market, and the investor is under no obligation to follow through with the option. But sometimes following through is a good way to negate a currency loss. For example, a person who bought an allotment of yen with dollars wants to hedge against the price of yen falling relative to the dollar. What he can do is buy an option to purchase the same amount of dollars using yen at the price for which he originally bought the yen. Since options only cost a small fraction of their denomination, this investor has just taken out an insurance policy on his long yen position for a relatively small amount of money. If the price of yen rises, then he has made a profit on his long position and he is just out the money he used to buy the option. But, if the dollar strengthens relative to the yen, he can always wait and exercise his option, buying additional yen at the now reduced rate as specified by the currency option. Thus, for a small option price, he has negated the loss he incurred when the dollar strengthened and the yen weakened.

By using instruments such as futures contracts and options, traders can hedge their currency positions for a fraction of what they paid for their original investment. Also, businesses operating internationally often hedge in the forex market as well, taking currency positions to offset any losses caused by fluctuation in exchange rates. Hedging is a powerful tool that serves well those who take the time to use it.