Forex hedging is a tool used to protect traders against losses. It means buying a contract that will rise in value and negate the loss caused by another contract. Hedging is recommended only for experienced forex traders.
Forex Hedging by Companies
Forex hedging is used by companies to negate forex risks while trading in the forex market. They follow a set of rules set by International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (US GAAP). All forex hedges of companies are listed on their balance sheet at fair market value.
Direct hedging happens when traders place a trade that buys one currency pair, and at the same time a trade is made to sell the pair. The profit here is nil when both trades are open, but more money can be made without taking extra risks if the market timing is just right. The advantage here is that your second trade can make profit, even if the market direction is against your first trade.
There are different ways of complex hedging. For example, a trader can hedge against a specific currency by using two different currency pairs. For example, the trader could go long on EUR/GBP and short on GBP/USD. If the pound appreciates versus other currencies, then there could the trader could be exposed to fluctuations in the currency pairs.
Forex options are agreements for having an exchange at a specific future price. For example, the trader places a long trade on EUR/USD at 1.27. For protecting that position a forex strike option at 1.26 is placed.
If EUR/USD drops to 1.26 within the time the trader has given for the option, then the trader receives a payout on that option. The amount of money that is paid depends on the market conditions at the time of buying the option, as well as the size of the option.
If EUR/USD does not touch that price in the specific time period, then the trader loses just the option’s purchase price.
Other Types of Hedging
There are other types of hedging products in forex such as currency forward contracts and exotics.
A currency forward contract is an agreement (subject to negotiation) between two entities to exchange specific currency amounts at a set rate on a particular trading day. Here, the advantage is that the future exchange rate has been set. Additionally, changes to interest rates in the future do not affect forward contracts.
On the other hand, exotics may be combinations of different hedging products with many different names. They come with limited downside risk and the possibility of unlimited or limited upside benefit. They are similar to standard options, but are mainly catered to very experienced forex traders because their complexity could hide extra profits for sellers.
To conclude, learning hedging techniques in forex is not very straightforward. If you are really keen to learn forex hedging techniques, then seek the help of an experienced trader or enrol in a short course which covers all areas of hedging. You will then be able to use hedging options effectively in the forex market.