What is Hedge in Forex? How to Hedge in the Forex Market?
Hedging in Forex is a method of opening multiple currency transactions to protect against an undesirable movement resulting from an existing position. The purpose of hedging is not to eliminate risk completely, but to reduce it to a known level. Because hedging also has costs and may exceed its benefits after a certain point.
The most common methods of hedging in the Forex market are spot contracts, currency options and currency futures. Spot contracts are standard transactions made by retail forex traders. Since the delivery date of spot contracts is very short-term (two days), it is not the most effective currency hedging tool. In fact, spot contracts are transactions that often create a need for hedging.
Currency options are one of the most popular currency hedging methods. Like options on other types of securities, foreign exchange options give the buyer the right, but not the obligation, to buy or sell at a certain exchange rate in the future. Standard option strategies can be used, such as long straddle, long strangle, and bull or bear spreads, to limit the loss potential of a given trade.
An example of hedging in Forex might be: For example, if a U.S. investment bank plans to transfer some profits it made in Europe, it might buy a currency option to hedge that transaction. Since the planned transaction is to sell euros and buy US dollars, the investment bank buys a put option that gives the right to sell euros. If the transaction occurs without hedges and the dollar strengthens or the decision remains constant, then the company only loses the cost of the option. If the dollar weakens, the profit from the currency option may offset some of the losses incurred in transferring the proceeds from the sale.
An important point to remember when hedging in Forex is that hedging is not a money-making strategy. The purpose of hedging in Forex is to prevent losses, not to make a profit. Additionally, most hedges only eliminate some of the risk, because eliminating all of the risk can be both costly and useless.