What is Hedging | Inside Forex trading

Hedging in forex simply means controlling or mitigating risk. A more elaborate definition of a hedge would define hedging as an adoption of any strategy or trade that provides a price movement that moves in a compensatory manner so as to enable a trader to offset the risk or loss incurred on another trade in the financial markets.

Hedging in the forex market can be done by traders to protect against losses in spot trades, or it can be done by businesses or corporations to protect against the losses they could incur on exchange rate fluctuations.

Hedging in Forex Trades

Hedging is one way of trading that separates the boys from the men in the financial markets. Many retail traders lost money in the global economic crisis of 2008, but professional traders who were properly schooled in hedging techniques were able to curtail those losses and in some cases, even made more money from their hedges than they lost in the parent trades. The common way of creating a hedge in the financial markets is to use a futures or options trade to hedge against a spot trade.

In the forex market, a popular hedging technique is to use a currency futures or currency options trade to hedge against a forex spot trade. When using a forex hedge in the options market, the trader takes a?contrary?trade to that placed in the spot forex market. In the options market, the trader purchases options either in a bullish (call) or bearish (put) direction. The trader is under no obligation to exercise the option before the trade expires, so he can decide to allow it to expire or he can decide to exercise it. What does this mean? Usually if the position he placed in the spot market is doing well, this will cause the options contract to move into a loss position or be out-of-the-money. This happens because as we said earlier, the hedge trade is contrary in position to the spot trade. When the trade expiry approaches, the trader can allow the options contract to expire if the spot trade is going well. When the options trade expires worthless, all the trader loses is the premium he paid for that trade, which will be covered by the profits made on the spot trade. If the spot trade is performing poorly, then the trader can exercise the options trade hedge, and exercising the option (i.e. selling off the contract to another buyer or to the dealer/broker) will give the trader enough profit to cover the loss in the spot trade. This is a simplified version of how a hedge trade works.

Hedging in Foreign Exchange Business Transactions

What has been illustrated above is how hedging is done by foreign currency traders. Foreign currency is not only used as a means of investment, but is also used as the medium of exchange in international business. In this situation, a business would be looking at protecting itself against sudden currency exchange rate fluctuations. A graphic illustration of how a currency fluctuation could affect a business is seen in this example. If a European company wants to purchase a raw material in the US for US$500,000 at the rate of 1.2500, it would require 400,000 Euros for the transaction. Supposing this deal was to be done on a Friday, and by some unfortunate circumstances, the deal got postponed to the next Monday and the exchange rate changed over the weekend to 1.2200, it would now require 409,838 Euros to carry out the transaction. For a business, a difference of 9,838 Euros could mean the monthly salaries of 10 workers lost in a single deal due to the fluctuation. In this instance, the company can use a futures contract or use a forex swap as a hedge against such a fluctuation.

So whether you are a businessman engaged in international business or just a trader looking to protect your spot trades, hedges are there for you to protect your investments.

Source: http://blog.forex4you.com/what-is-hedging/

alabama vs lsu alabama vs lsu bcs championship game beyonce baby detroit auto show tebow broncos ben roethlisberger