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What You Should Know About Forex Hedging?

September 26, 2021
by Leon Marshall,

Article Recap

Forex hedging is a term used in the Forex industry where one currency is exchanged for another. 

The thing that stands out the most about Forex trading is the fact it relies on exchange rates that fluctuate in accordance with changes in supply and demand. This is where currency hedging comes into play. It is a term used in the Forex industry where one currency is exchanged for another. 

The roots of hedging grow deep, but their modernization came in the mid-twentieth century when Alfred Winslow Jones created what is called a hedged fund. His motivation was simple – protect clients from market losses by creating insurance against risk. Jones began by short-selling stocks or selling stocks when he thought their value would decrease, and bumping the leverage. 

What is currency hedging?

To begin your journey through hedge trading, you should first grasp the most essential concepts on which it is built. The Forex market is one of the most volatile ones out there. This means that the higher the demand for a currency, the higher the prices will go. Both individual traders and large-scale companies can suffer huge losses when rates change drastically. As a layer of protection from these fluctuations leading to considerable negative impact, they enter a so-called currency hedging financial contract. 

The act of protecting one’s finances from currency exchange rate changes is what currency hedging is all about. Be it a business or an individual who does it, be it an expected or an unexpected change, it applies as long as the contract is active.

How does currency hedging work?

In order to make use of this tool, it is important to be aware of how the Forex market functions. For instance, whom to sell to or where to buy from, or in other words, clients and brokerages. Once these are cleared up, a level of protection from exchange rate changes can be established. Not doing so could result in unforeseen losses.

To double down on the methods of currency hedging there are two that stand out – fixing and using the same currency to buy and sell products. The first one uses derivates, or bank contracts with the goal of protection, to fix exchange rates prior to the processing of payments. The second one is usually done by businesses due to larger fundings in areas where it is possible that said changes can be passed on. 

In both cases, the negative repercussions of currency fluctuations are somewhat or entirely avoided. Learning the ins and outs of currency changes’ impact and natural hedging is crucial to continued trading well-being. That’s the case for both smaller businesses and individuals.

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The pros and cons of currency hedging

Forex hedging has its advantages and disadvantages. They are related to the traders’ needs and possibilities.

The advantages

Protection from losses and negative market changes

Traders and businesses that utilize hedging programs, upon seeing the exchange rate volatility at a given moment, can decide to stop trading or wait until the rates are back up to resume. Either way, they are loss-insulated/protected to a degree. This tool also provides an outlook over changes that can be used to plan out increases or decreases of trading activities during a period of time and monitor how their business is affected. It can be used to navigate other types of economic downturns as well, including inflation, commodity price, and interest changes.

Grounded understanding and potential for predictability

Provided enough time and a specific duration set for monitoring a hedged item at a hedged rate, the profit and loss movements can be foreseen. Large-scale corporations such as banks record hedge revenue and any impact on it.

This is a step in the direction of getting to know a currency’s value in advance. As mentioned above, planning over a period of time is an option used to look into the potential modifications to a strategy and all trading activities associated with it. 

Time-efficient

Simply put, the constant need to always be on top of currency pairs price falls and rises disappears. That would, of course, apply only to those who trade short-term as do day traders. Without having to check the system all the time, it becomes easier to focus on other tasks.

The disadvantages

Not ideal for all kinds of traders

The act of currency hedging mostly benefits traders with sufficient experience who have a deep understanding of the market. And even in those cases, they are not always successful in their decision-making strategies. Beginner traders should first opt to connect as many dots as they can from the network of Forex trading before going down the route of currency hedging.

Requires considerable funding in the long run

Not all individual traders, even with experience, can invest in this tool and see profits. After putting in the funds, traders have to be patient and consistent to notice those income numbers potentially rise over time.

Risk management can come at the cost of smaller gains

There is a price to pay for everything. Traders that go for currency hedging lose a portion of their ability to react quickly to market movements. This reduces the amount of risk and protects from losses but it also affects rewards. Long-term, currency hedging can be profitable, but it should not be viewed as a method to maximize gains. 

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Trading on margin is high risk.

All times are AEDT.