Foreign Exchange Hedging Strategies
Foreign exchange hedging is a tactic used by some forex traders to protect an existing or planned position from negative price moves. The correct use of hedging allows traders with a long position on a forex currency pair to protect themselves from a price fall, and vice versa. In a sense it is like insurance: you are taking out a position that will pay you if the worst happens. However it is more flexible and therefore more complex than insurance.
Assuming that your first position is a spot forex transaction, you can either hedge with another spot order or with another form of trade, the most popular of which is a position in forex options. This avoids the problem of the short delivery date of spot contracts because options give you the right, but not the obligation, to buy or sell the currency pair at a certain price at some time in the future. It is also possible to hedge with the other major derivative, currency futures.
Foreign exchange hedging strategies have four steps. It is important to go through each step carefully because the effect of making a mistake will almost certainly be that you have less protection or higher costs than you anticipated.
Step 1 – Analyze your risk
The first step is to calculate the risk that your current or planned position is subject to, and whether it is too high for the current market. This may have altered since you opened the position.
Step 2 – Consider risk tolerance
This relates to your own risk tolerance. This should not depend on your current fears or other feelings but is at a level that would apply in any similar situation. The aim of hedging is not to reduce the risk to zero but to remove what you cool headedly consider to be excess risk.
Step 3 – Decide on your forex hedging strategy
Considering the cost of various possible hedging strategies using spot or currency options, determine which is the most effective.
Step 4 – Implement
Then go ahead and act on your chosen strategy. Be sure to monitor it through any market changes that may affect the need for it or its effectiveness.
Forex trading is always risky and hedging is one way that some traders use in order to reduce their risk in certain circumstances. Risk management and money management are vital trading skills and are probably as important as your trading system and trading plan in your success as a trader. So it is very useful to increase your market responsiveness by adding an extra possibility like foreign exchange hedging to the position management choices that you have.
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