Hedging in Forex: An Introduction
In general terms, hedging is something we often do in our everyday lives. Perhaps without even realising, many of us are involved in hedging each day. Hedging simply means to lessen the downfalls of losing out on an investment you’ve made. The widely accepted Oxford definition of hedging is:
- “to protect oneself against loss on (a bet or investment) by making balancing or compensating transactions.”
That gives us a general idea behind what hedging is. In real life, we are hedging when we take out insurance on certain things. For example, we might take out life insurance. This is done with the aim of lessening the negative financial impact of losing a loved one. Alternatively, we might take out home insurance to protect our assets and belongings. Insurance plans involve paying a small fee, perhaps each month. This fee gives us access to an insurance pay out, should something bad happen to our assets or loved ones. To some extent, this pay out mitigates the burden of loss, by helping us out financially. So, what is hedging in forex?
You might have heard the term “hedging your bets” before. You may or may not know what this means – it’s all about protecting yourself against the potential losses associated with betting. In some ways, investing in stocks is taking a gamble. As there’s a risk involved, you could possibly lose money. Hedging in forex is a way of protecting yourself against the damages caused by potential risks associated with investing money in stocks. Read on for our full guide to hedging in forex. Find out what hedging is, how it works, and how you can potentially use hedging in forex to your advantage.
Real-World Examples of Hedging in Forex
While some investors see hedging as a little complicated, it’s certainly true that all traders can get involved with hedging in forex. All it takes is the determination to wrap your head around it, a good broker to help you through it, and information from the right sources.
When hedging in forex, you might have decided to invest in one company you really believe in. Despite your positive regard of the company, you are a little wary of their upcoming competitor, who offers a very similar product. In order to limit the losses of your investment if this competitor does win the market share and beat your original preferred company – you might decide to also purchase shares in the competitor.
Hedging in this sense involves considering long and short investments. You can choose to go long on your preferred company who is making profits. This means you’re investing with the expectation that their share value will continue to rise over time. Then you can hedge this investment by implementing a backup plan, just in case that company is unexpectedly beaten by their competitor.
This is where you’ll invest by shorting their competitor; both investments made in equal amounts. In shorting the competitor, you are predicting that the value of their stocks will fall on a short-term basis. Therefore:
- If the market makes an overall profit and your selected investment proves to be a hit: you’ll make profits on your initial investment, making only a small loss on your secondary hedge investment.
- If the competitor company actually outperforms your initial investment: you’ll lose money on the first investment, but you’ll make money that mitigates this loss on the backup investment.
Hedging becomes a much more popular phenomenon in forex when markets become unpredictable. For example, during a recession, hedging becomes more commonplace. Or, investors may predict a particular market they’re investing in will experience financial turmoil. They may therefore decide to mitigate potential losses by planning ahead and hedging.
Positives of Hedging in Forex
There are plenty of bonuses to hedging in forex: that’s why people do it. Trading has many risks, and the market can fluctuate based on a whole variety of outside influences. These range from inflation to currency instabilities. Many traders therefore see the positives of hedging in forex. Here’s just a few of the bonuses.
- Reduce the financial losses associated with trading. Trading isn’t a guaranteed way to make money. You might make some losses, especially if you’re just starting out. Hedging can help you offset the money lost when one investment goes bad. This is because you’ve invested in a kind of backup plan, one that means the financial loss you made on your initial investment doesn’t seem so bad.
- Protect yourself against unpredictable market changes. All traders know just how much the market can fluctuate. Some traders suffer the downside of these changes drastically, particularly if they haven’t hedged their investments.
- Feel more confident about your investment strategies. Investing can be a worrisome process for some. If you find yourself feeling nervous about your investments, hedging is worth a try. It can alleviate some of that worry, simply to know that you have a security investment in place.
Negatives to Hedging in Forex
As with any investment move, hedging in forex does not come without its risks! These risks, however, can be quite small. Think of the negatives in terms of taking out life insurance. You’re spending a small fee on something that will pay out in the long run, but for now, there is a small cost. Overall, you’re better off taking out life insurance than not.
- Some strategies for hedging in forex can still result in losses. When you partake in hedging, you are making another investment (that may offset potential losses if the initial investment goes badly). The investments you’re hedging may result in losses themselves. As with any investment strategy, it’s worth outweighing the pros and cons in considering whether hedging is the right choice for you.
- Reducing the risk of investing by hedging does cost money. However, you are left with less risk of losing more money. When you lower the risk of investing, you also lower the potential profits you can make – because you’ve put money into hedging.
- Hedging can take a lot of time and experience to get right. Even some of the most seasoned investors are still learning. You can get ahead of the game by investing time in some of the most reputable resources available today. Read up on hedging in your spare time, as knowledge is power.
- Hedging is not so advantageous when markets are doing well. Putting extra money into mitigating the risk of investing is not as appealing when the markets you’ve invested in are already growing! However, markets are not altogether predictable, and you may still benefit from doing so.
Hedging in Forex: Key Strategies
There are a few different strategies you can use when considering hedging in forex. Here are just a couple of the ones you can choose from:
- Simple Hedging in Forex
This is the example we provided earlier. Options hedging is where you put investments into two competing sides of the market, with the expectation that one will outperform the other.
- Multiple Currency Hedging in Forex
Part of forex is using multiple currencies, and people do this to hedge, too. When one currency goes up, another correlating currency often goes down. Hedging via currency investments means putting multiple investments in different currencies that will balance out any potential losses due to currency fluctuations.
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