What is hedging in forex?
|What is hedging in forex?|
In this article, we are going to explain hedging in forex. Hedging is a strategy in trading forex, in which a position is protected against unwanted price variations, by another position in an opposite direction. When traders are worried about an event and the instability it could cause, they can use hedging strategy to safeguard their assets against the volatility of the market.
Hedging means protecting your assets against an unfavorable event. For example, when you buy insurance for your car, you have in fact protected your car and yourself against a potential disaster. In other words, you have used hedging strategy to protect yourself.
In forex, hedging acts like an insurance for your financial positions. Hedging is a way to decrease the risk in case an unpredictable event happens.
What is hedging?
The best way to understand hedging is to think of it as an insurance. When investors hedge, they intend to protect their assets against possible loss. However, hedging doesn’t eliminate risk entirely, but with proper hedging strategies you could reduce the amount of loss.
Traders use hedging strategy to reduce risk. However, hedging in financial markets isn’t as simple as buying an insurance for your car. Hedging against investment risk means using financial instruments and strategies to eliminate the undesirable effects of unfavorable events. In other words, an investment could be hedged by doing another one.
To be able to hedge, assets must be used that have an opposite effect on the main investment. However this kind of insurance will have certain costs that you should pay in different forms.
For example, if you are holding shares of a company, you could use a put options to protect your investment against risk. However, you should pay the costs of this contract. Or if you have traded a certain currency pair in a forex broker, you could obtain the opposite direction and hedge your first positions against risk.
Therefore with risk decreasing, you should sacrifice a portion of your profit. So you should be aware that hedging is a method to decrease risk, not to increase profit. If the investment you have hedged makes profit, the amount of profit would decrease. However, if your investment fails in this case, you would be protected against loss.
Hedging techniques usually include using derivatives. Two common derivatives used in hedging are options and futures contracts. By utilizing derivatives you can develop strategies to cancel out the loss caused by one investment by the profit gained from another one.
Imagine that you hold the shares of a company. Although you hope to gain profit in the long-term, you are worried about short-term losses. In this case, to protect yourself against any possible loss, you could sell this shares in the future at a certain price using a put option. This strategy is known as “married put”. If the price of your share falls below the specified price in the put option, the amount of loss that your shares suffer would be canceled out by the profit you’d make with your put option.
Another common example of hedging, is used when a certain company relies on the price of a certain product. Imagine that a company is worried about the price of raw material it needs to keep its production running. If the price of this material skyrockets, the company will be at major risk. Therefore, to protect itself from such risk, the company can use a futures contract. A futures contract enables the company to buy its essential raw material at a certain price in the future. Now the company would be able to adjust its budget according to the amount of raw material it needs, without being worried about the price fluctuations of this material. In this case, if the price of the raw material skyrockets, the futures contract protects the company from this raise in value.
Each hedging strategy comes with a certain cost. Therefore, ask yourself if the profit gained from hedging strategy compensates this cost. Also have in mind that the purpose of hedging is not gaining more profit. Hedging can only protect you against potential loss. Cost of hedging could be the cost you pay for an option contract or suffering loss from a futures contract. Nevertheless, these costs are inevitable.
What hedging means for retail investors
Many investors don’t use derivatives. In fact, many long-term investors neglect the short-term volatility of the market. Therefore, hedging seems unnecessary for this kind of investors, because they let their investment grow with the market.
Even if you don’t use hedging in your entire life, you should know how it works. Many large companies and investment funds use hedging in a way. For example, oil companies may hedge their assets against oil price variations, and an international mutual fund may hedge the fund against price variations of the currency market.
An example of forward hedging
Another classic example of hedging involves a farmer and the futures market of wheat. The farmer plants the grains in Spring and sells the product in Fall. Meanwhile, the farmer is at risk, because the price of wheat may decrease until Fall. While the farmer wants to gain the most amount of profit possible, he doesn’t want to be exposed to price variations of wheat. Therefore, when he plants the grain, he could sell his wheat at a certain price (e.g. 40 U.S. Dollars for each stack) six months away. This is known as the forward hedge.
Now imagine that six months have passed and the farmer wants to sell his product. If the price has reached 32 U.S Dollars for each stack, the farmer could buyback his futures contract for 32 U.S Dollars for each stack and gain 8 U.S Dollars per stack. In fact, the farmer wouldn’t suffer loss, because he would gain 8 U.S Dollars per stack from the futures contract and gain 32 U.S Dollars per stack from selling his product. So he would eventually get 40 U.S Dollars per stack.
On the other hand, imagine that the price of wheat had increased to 44 U.S Dollars per stack. In this case, the farmer would sell his product for 44 U.S Dollars per stack and he would also suffer 4 U.S Dollars loss per stack. SO he would also eventually get 40 U.S Dollars per stack.
Risk is an inevitable factor of investment. Regardless of the kind of investment, the investor should be familiar with the concept and mechanics of hedging and know how different companies hedge their assets against possible loss.
Even if you don’t have any intention to use market derivatives, having a basic knowledge of their concept could improve your understanding from the market and help you in your journey.
Aron Groups Broker facilitates trading by offering MetaTrader5 platform to its clients. Using MetaTrader5, traders are allowed to trade several financial instruments such as Stock, Energy, Commodity, Cryptocurrency and Currency pairs, benefiting from both “Netting” and “Hedging” strategies. Therefore, Aron Groups clients are able to hedge their assets against possible loss.
Written by: Mohsen Mohseni (Aron Groups).