If you are just starting out in trading you may have come across the term hedging and wondered what it’s all about. Read on to find out what is hedging and why it can be important.
Hedging is a strategy applied to reduce the amount of loss incurred in case of occurrence of an unfavourable event. Hedging only reduces the negative impact of an event on an investment but cannot prevent the adverse event from happening.
A hedge is an investment that protects against adverse changes in prices on investments. Corporations and individual investors are the ones who mostly use hedging in their investments to reduce their risk exposure. You can look at it like having an insurance policy. When investors hedge, it simply means they are insuring themselves from a negative event. Hedging isn’t actually allowed everywhere, but some brokers like Hot Forex have no restrictions on hedging in trading activities.
What’s Involved in Hedging?
Hedging involves making an investment that moves in the opposite direction to the original investment, with the aim of protecting the original investment. Investors who hedge mostly use derivatives. Derivatives are financial contracts whose value is based on an underlying asset. The most common derivative is an option. It gives you the right to buy or sell an asset at a specified price in a given time period.
For example, let’s say you buy a particular stock where you are sure price will go up on, but you still want to protect your investment against loss if the price drops. You will buy a ‘put’ option which means you bought the right to sell the stock at the same price. If the price falls, you exercise your right and make back the money you invested.
Hedging in Forex Trading
Hedging in the foreign exchange market is about protecting a trader’s position against an adverse price movement in a currency pair. Traders use the following ways to hedge;
Direct hedging. This is where a trader is allowed to enter a trade to buy a currency pair and then places another trade to sell the same currency pair. The benefit of this strategy is that it enables traders to hold their positions in the market and make gains from their second trade in case the market moves against the initial trade. Some brokers allow this kind of trading while others do not.
Forex options. This is an agreement to engage in a trade at a future period at a specified price. For example, a trader who has entered a long trade may buy a put option contract to reduce risk in case the currency price drops, while a trader who is in a short position may buy a call option contract to reduce risk if the currency prices move up. A put option contract gives the trader the right but not the obligation to sell a currency pair at a specified price. A call option gives the trader the right to buy a currency pair at a specified price.
The Importance of Hedging
- It limits risk exposure. Hedging helps to reduce the risk for investors in case of an unexpected negative occurrence. This prevents investors from making huge losses.
- It also helps determine sale or purchase price of assets. This is made possible through the use of options and futures.
Limitations of Hedging
Costs. Hedging tends to reduce the potential profits earned from an investment. A cost-benefit analysis should be done before you start using this strategy.
Take note, risk is inevitable in any investments that are made and you should not invest more than you can afford to lose. This is why investors apply different strategies in order to reduce risk instead of trading blindly. Hedging is one of those strategies. It is important that you to learn how hedging or other trading strategies work before implementing any of them in your investments.
When done correctly, hedging can be an effective way to reduce risk, manage your trades, and protect your overall account balance.