Hedging - Is It A Good Idea? - By: Owen Moore

If we don’t understand the significant risk involved in hedging the risk we aim to avoid by entering a hedge may be less than the significant losses we may incur. It is therefore obligatory that you know the pros and cons of the risky strategy that is hedging.

Definition

Currency Hedging involves utilizing a strategy by purchasing a foreign exchange option or by directly opening a position in order to protect you against unprofitable movements in the forex market. Accordingly an investor which we assume has made the correct decision to undertake a long hedge position has protected him from downside risk and an investor which has undertaken the correct decision to undertake a short hedge position will protect himself from upside risk. There are two ways of hedging :

1. Spot Contracts: These are the usual contracts we encounter on a daily basis. They are not frequently used because of their short term nature.

2. Option contracts: These give you the right but not the obligation to trade as undersigned on a particular currency pair in the future. These are the preferred hedging vehicles due to their long term characteristic.

Advantages of Hedging

-It minimizes probability and magnitude of losses in the short term when used by longer term traders.

-It can be used for capturing profit.

-It can aid during difficult market periods.

-when utilized correctly it can shield you from commodity price changes, interest rate changes, etc

-It can also save time as the long-term trader is not required to monitor/adjust his portfolio with daily market volatility.

-Hedging using options provide the trader an opportunity to practice complex options trading strategies to maximize his return.

Disadvantages of Hedging

-It is costly therefore must be carried out in prudence.

-Decreasing risk usually goes along with a decrease in profits.

-It is not practical for the short term trader. Why? Because the currency market is more volatile and more unpredictable when analyzed from shorter time frames.

If the market is performing well or moving sidewise, then it offers little benefits.

Using hedging may require you use an account of higher category e.g. with a higher account balance.

It may be very complex for beginners so it is therefore advisable only for experienced traders with good trading skills.

As with all trading methods, risks are involved. And this risks can lead to huge losses. And so before deciding to utilize it you must understand its underlying concepts adequately.

About the Author

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