What is hedging in Forex and how it works?
It seems that risks hedging is very similar to the diversification of risks at Forex. However, although the targets of these strategies are similar, the ways of reaching these targets are different. Hedging of risks means protection from price fluctuations of the traded assets. By using this method you eliminate unexpected surprises related to trading in the currency market. Hedging can be compared with the insurance.
A trader can hedge risks by taking equal and opposite positions in two different markets.
Methods of hedging
Depending on the purpose we can allocate two types of risk hedging: stock exchange and outside stock exchange. In the first case, hedging involves swaps and forward contracts; the latter involves options and futures contracts.
Hedging techniques are divided into classical, partial, full and anticipatory.
- Classical hedging is also called a “pure” hedging. This method is utterly transparent. In order to eliminate risks a trader opens two opposite positions simultaneously but in different directions. If the forecast proves to be wrong, the losses will be compensated.
- Full hedging insures against risks for the whole sum of the deal. Partial hedging implies the insurance only of a part of the deal.
- Anticipatory hedging is used for sale or purchase well before making a transaction on the market. This type of hedging is common on the stock market and is used by the experts of the financial market.
A thoroughly and thoughtfully selected strategy will help successfully hedge risks at Forex market. You can trade using a strategy based on the time of trading sessions or on news; in any case, type of hedging shall be in alliance with the trading strategy. However, there are general types of hedging strategies. Let’s look at three of them.
- Futures contracts as a tool of hedging
- Hedging risks by purchasing options of
- Buy put
- Sell call
Futures contracts as a tool of hedging risks
What is an advantage of a futures contract? It enables us to carry out transaction on the currency pair whenever we think is the best time to do it, but at today’s market price. It means that the purchase of the futures contracts enables us to make a deal at any time at today’s price. Futures are used for hedging risks. The volume of the deal, which you are going to hedge, should be equal to the number of your futures contracts. In case of the adverse price movement, you can hedge your risks by selling contracts, which you bought before.
Hedging risks by purchasing options
- Put option gives the owner the right to sell a specified amount of assets at a specified price within a specified time. A holder of the put option estimates that the underlying asset will drop below the exercise price before the expiration date
- Call option provides a holder the right to purchase an underlying asset at a specified price for a certain period of time. Investors buy calls when they think the share price of the underlying asset will rise or sell a call if they think it will fall.
A few examples
The most widely-used example of risk hedging is illustrated in the agricultural business. Just imagine that you are involved into grain production. Our business depends on the weather. In a bad season, when the harvest is low, you will have to raise prices, in the years of good harvest and oversupply in the market you will have to sell grain at a lower price. What can you do? Risks are not acceptable for development of your business. You can conclude a contract, which specifies fixed price and period for which this price is valid. This contract will protect you from possible losses.
Here is another example with the same business. We sell grains, evaluating costs in the USD. However, market volatility makes grain prices unstable. In this case, our contract can specify fixed exchange rate valid for the period of the contract, which will be used for making payments between the partners.