By Adinah Brown
Online trading has opened up a wide array of possibilities for traders, however, it has also opened up a new and never-before-seen level of risk. The speed at which transactions take place today, the emotional rollercoaster triggered by the possibility of instant gratification and the opportunity to make money in seconds, often causes traders to treat trading as gambling, and not as a professional business requiring educated and savvy speculative habits. When trading is not given the seriousness it deserves, risk management takes a back seat. Add to this the high levels of leverage offered by most forex brokerages, and you end up with a magnified risky venture.
This is why you’ll come across article upon article written on the subject of risk management. One way in which traders can help minimize the level of risk they take on in their trading is by hedging. Having a tool like hedging in your tool chest can be outstandingly useful in a venture that is as risky as foreign exchange trading.
What does hedging mean? Forex hedging is basically a transaction that is put in place by a trader in order to protect a position from unwanted or unexpected moves in currency exchange rates.
In order to implement an FX hedging strategy effectively, you must first analyze your risk exposure. Identify the amount of risk you’re currently are exposed to (or will be exposed to upon opening a proposed position) and what the implications would be if you did not hedge against this risk. Provided that the market remained at the current level, what would your risk be?
Once you determine the level of risk you are exposed to, determine whether this is an acceptable risk. How much of your current exposure are you willing to risk? How much are you willing to pay to avoid that risk? That relationship between risk and amount to be paid to remove it will determine the amount you need to hedge.
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Now choose the type of hedging strategy you want to implement. Choosing the most cost-effective hedging strategy is part of your risk management success, as over-hedging or overpaying to hedge, can prove to be bad trading practice. Two of the most common hedging strategies are multiple currency pair hedging and forex options hedging. Although only recommended when building a complicated hedging plan that takes into consideration several currency pairs, hedging using multiple works essentially by using two different currency pairs to hedge against a particular currency.
Let’s say for example that you want to hedge your USD exposure on a long EUR/USD, then you would short on USD/CHF. The downside of this is that if the euro becomes stronger against all other currencies, the fluctuation in the EUR/USD would not be countered in the USD/CHF.
The second hedging strategy I want to discuss is Forex options. A Forex option is basically an agreement to exchange at a predetermined price, at some point in the future. For example, if you place a long EUR/USD at 1.45, you would place a forex strike option at 1.44 in order to protect that position, so that in the event the EUR/USD falls to 1.44, within the timeframe specified in your option, you get paid on that option. If the currency pair doesn’t reach the specified price in the option, all you risked was the option purchase price. The farther your option at the moment you purchased is from the market price, the larger the payout if the price is hit within the time you specified.
About the Author:
Adinah Brown is a professional writer who has worked in a wide range of industry settings, including corporate industry, government and non-government organizations. Within many of these positions, Adinah has provided skilled marketing and advertising services and is currently the Content Manager at Leverate.