When traders talk about hedging, what they often mean is that they want to limit losses but still keep the potential to make profits. Of course having such an idealized outcome has a hefty price. Ultimately to achieve the above goal you need to pay someone else hedging forex pdf dummies cover your downside risk. In this article I’ll talk about several proven forex hedging strategies.
The first section is an introduction to the concept which you can safely skip if you already understand what hedging is all about. The second two sections look at hedging strategies to protect against downside risk. Pair hedging is a strategy which trades correlated instruments in different directions. This is done to even out the return profile. Option hedging limits downside risk by the use of call or put options. This is as near to a perfect hedge as you can get, but it comes at a price as is explained.
Hedging is a way of protecting an investment against losses. Hedging can be used to protect against an adverse price move in an asset that you’re holding. It can also be used to protect against fluctuations in currency exchange rates when an asset is priced in a different currency to your own. Hedging might help you sleep at night. But this peace of mind comes at a cost.
A hedging strategy will have a direct cost. But it can also have an indirect cost in that the hedge itself can restrict your profits. The second rule above is also important. The only sure hedge is not to be in the market in the first place. Simple currency hedging: The basics The most basic form of hedging is where an investor wants to mitigate currency risk. Let’s say a US investor buys a foreign asset that’s denominated in British pounds.
For simplicity, let’s assume it’s a company share though keep in mind that the principle is the same for any other kind of assets. The table below shows the investor’s account position. Without protection the investor faces two risks. The first risk is that the share price falls. The second risk is that the value of the British pound falls against the US dollar. Given the volatile nature of currencies, the movement of exchange rates could easily eliminate any potential profits on the share. To offset this, the position can be hedged using a GBPUSD currency forward as follows.
GBPUSD at the current spot rate. The volume is such that the initial nominal value matches that of the share position. At the outset, the value of the forward is zero. If GBPUSD falls the value of the forward will rise. Likewise if GBPUSD rises, the value of the forward will fall.
The table above shows two scenarios. In both the share price in the domestic currency remains the same. In the first scenario, GBP falls against the dollar. This exactly offsets the loss in the exchange rate. Note also that if GBPUSD rises, the opposite happens. The share is worth more in USD terms, but this gain is offset by an equivalent loss on the currency forward. In the above examples, the share value in GBP remained the same.
The investor needed to know the size of the forward contract in advance. To keep the currency hedge effective, the investor would need to increase or decrease the size of the forward to match the value of the share. As this example shows, currency hedging can be an active as well as an expensive process. For FX traders, the decision on whether to hedge is seldom clear cut. In most cases FX traders are not holding assets, but trading differentials in currency. Book value set for the classic trading strategies: Grid trading, scalping and carry trading. All ebooks contain worked examples with clear explanations.
Learn to avoid the pitfalls that most new traders fall into. Carry traders are the exception to this. With a carry trade, the trader holds a position to accumulate interest. The exchange rate loss or gain is something that the carry trader needs to allow for and is often the biggest risk. A large movement in exchange rates can easily wipe out the interest a trader accrues by holding a carry pair. This is a type of basis trade.