Hedging in forex protects investors from the volatility and uncertainty of financial markets. With forex hedging, the strategies refer to the act of an additional buy/trade of currency to offset the risk involved in the initial buy/trade. It is a method of insurance for forex traders, but should only be used by experienced traders who understand the ups and downs along with timing in the market. Adopting a hedging strategy without sufficient trading experience can make for disastrous impact on your account.
Hedging in the market involves a trader investing in multiple positions to minimize the risk by taking a negligible loss or a small profit, irrespective of the market volatility. The primary goal behind hedging is to cover all market eventualities and to prevent significant losses in trading. Hedging is used by traders if they are not sure about the future course of the market, and if they anticipate massive swings on either side of their trade position due to unpredictable news outcomes. In forex trading, hedging works on the principle of a trader buying and selling currencies at a single entry price or two different strike prices to ensure that he is protected even if the market swings violently in either direction.
Protecting profit margins is the most common objective in foreign exchange hedging for commercial and corporate businesses. Protecting margins typically falls into one of two categories – either your Cost of Goods Sold (COGS) or your International Sales Revenue. The basic principle is to protect your gross margins from erosion due to fluctuating exchange rates. If your gross margins are tight (<5%), then your requirement to protect those gross margins is very high. This, in turn, drives your strategy. A 5% or greater move in the currency could wipe out your profitability.
Currency hedging strategies can be implemented in different ways and can vary based on the investor’s potential goal. You can have a systematic approach in place that mitigates risk when your exposure reaches a specific level, or you can use a discretionary approach when you perceive that the risks of holding directional currency risk outweigh the potential gains. Many traders will also use a currency option hedge to mitigate their forex exposure.
Overall, hedging forex positions can offer unique ways to manage risk in your positions. Whether you use futures or correlated instruments, you can find ways to moderate your exposure without having to get stopped out all the time. The key is to understand your perspective thoroughly and accepting the costs that are involved in the type of adjustments you will have to make. As you become more experienced you will be better prepared to use creative solutions like hedging to control risk and reduce the anxiety in your trading process.