Percentage in Point

Posted: 06 Mar 2011 06:00 AM PST

Hedging is defined as making an investment to minimize the risk of adverse price fluctuations in an asset. Actually investors use this tool whenever they are not sure about the market’s upcoming events.

Similarly, in Forex market, Forex hedging takes place. Traders use this strategy to reduce the risk in trading. Although, Forex hedging cannot eliminate all the risk or other damages occurred in the market that causes to affect the trader's funds, but a proper hedging is likely to minimize the negative effects on those stocks.

Following are some important points that should be kept in mind while using hedging.

Which Currency Pair Protects Which Type Of Risk?

Basically there are two types of risk, i.e. downside risk and upside risk. When you are long in currency pair, you can use hedging to protect yourself from downside risk. On the other hand, if you are short in currency pair, then you can use hedging to protect yourself from upside risk.

The Easiest Method To Implement Hedging

A simple and easy way to for implementing a hedging strategy would be to make a transaction which involves another currency. Definitely, this currency will have a negative relationship with currency you used in the first transaction. For instance, you are using a currency pair USD and Euro. So if you are going long in USD, and an event in the world leads to either USD or Euro increasing, with other the other currency falling, then you can protect yourself by going long on Euro. So in this way, it does not matter which currency increases, you will make the profit.

The experienced traders know better the usage of hedging. For them, hedging can really reduce the losses, but there are some risks involved in hedging which should be considered before getting started the hedging. They are described next.

Hedging Comes At A Price

You should remember that hedging is not free of charges. Whether you needed them or not, you will have to pay for the hedges. Therefore, you need to make sure yourself that hedges are worth the money you are going to spend on them. You have to assure that the expected negative result will not happen. In case you cannot justify the money you are going to spend on the hedge, then you should not hedge your primary investment.

Forex Hedging In Itself Does Not Make Money

The important characteristic of hedging is that it does not make money in itself. Rather, hedging can help protect your funds from adverse and unexpected events that could cause the loss of your primary investment. So you should make it sure that hedge will protect you from such unhappy circumstances. The traders who are not experienced or do not know much about Forex hedging may think that they are protected to a high extent by a hedge they execute. After an unexpected or adverse event, they should find out that the hedge did not protect them as they expected. It can result not only a big loss from the primary investment, but also the cost of the hedge will be paid by the traders.

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