Hedging is a word that any trader in the stock or Forex market will know. To begin with, hedging means covering the exposure risk in one market/security by taking an opposite position in another market/security. Hedging is used to minimize the risk behind the market exposure. It acts as a strong support to fall back on, in the event of losses.
Forex traders often use derivative instruments to diversify the risk. Derivative instruments are known to be used widely to minimize risk exposed in some other area. Forex trading is all about gaining advantage out of the price variations between the currency pairs. A Forex trader who doesn’t know the word “hedging” should better not indulge into Forex trading.
Many traders consider ‘hedging’ as an insurance tool for their trades. The widely used derivative instrument by Forex traders is futures. A currency future is a contract to buy or sell a specified currency at a last closing price at an agreed future date. Currency futures are traded on the market like any stock or currency. Traders indulge into futures contract to hedge the currency exposure risk and exchange rate risk. If a trader has gone ‘long’ in YEN using USD, he will be worried the YEN rate falls more than the USD. To hedge his currency risk, he will sell a futures contract on USD using YEN.
Futures are largely affected by external market components and hence the futures contract will offset the long position in YEN. The futures price increases with a fall in rate of YEN and vice-versa. Therefore the trader here smartly eliminates his currency risk with the futures. Other derivative instruments can be forwards, forward rate agreements, currency swaps, interest rate swaps, Forex swaps etc.
Hedging in Forex can be done with another yet good instrument, options. Currency options are the derivatives where a buyer has a right (not obligation) to purchase/sell currencies for a pre-determined price, by paying a premium to the “seller” of the option contract. Options are traded O-T-C and are not exchange regulated. Since the buyer is not obliged to exercise the option, it turns out to be a very good tool to eliminate losses. If the currency movement goes in the opposite direction than expected, the buyer is at loss ONLY for the premium he has paid to the “seller”. Hence the loss remains minimal and can be avoided.
Margin trading is a main feature of any Forex market. A trader may have a capital of $1 million to invest, but with margin trading he can take positions in multiple times of his capital. This is termed as “leverage”. Forex market is usually governed by larges corporates dealing in foreign exchange trades, exporters, importers and other traders who engage in day trading to make quick money. The need to hedge arises from protecting oneself from the currency exposure and exchange rate risks.
With proper hedging, a trader eliminates the risks associated with the currencies and their volatile movements.