There are numerous ways of trading forex and hedging is one of them. The hedging options are used by a number of traders as it is less risky than other strategies. The hedging foreign exchange trading strategy has four parts which must be noted before any trade can be executed. In order to use this strategy successfully you must have an understanding of these different steps.
The trader and hedging
A forex trader will generally use a hedging strategy when looking to protect a potential position from fluctuations within the forex market. Traders who use a hedge fund when buying a currency with rising value will be able to protect themselves should the market show a downward swing. Furthermore, this type of trader can purchase a currency that will potentially show a downward swing and protect themselves from the risk of an uptrend. There are two primary ways in which hedging can be used in the forex market, via spot contracts and options contracts.
1. The spot contract
A spot contract is the most frequently used contract on the foreign exchange trading market. However, this is not the ideal way of handling hedge trades as it has a short-term trading time frame. The trading time period of a spot contract is usually two days which is too short for a hedging strategy. It may be argued that the hedging strategy is required due to these short-term spot contracts.
2. The options contract
The options contract is the most popular and effective means of hedging foreign currency. By utilising the options method a trader is allowed the option of selling and purchasing currency at an exchange rate in the future. There are some strategies in addition to hedging which can be used to trade options efficiently and limit potential losses in trading.
Building a hedging strategy
As is aforementioned, there are four parts to building an effective hedging strategy. These steps include: risk analysis, risk tolerance, identification of a strategy and implementation of the strategy. Only through complete understanding of the steps can you successfully develop and use a hedging strategy.
1. Risk analysis
Risk analysis involves a trader identifying the potential risks in a trade and where they are found in that trade. When these risks are noted the trader must determine whether the risk is greater in a hedged or un-hedged trade. By acknowledging this, and placing it within the context of the current market condition, the trader can determine whether the trade has low or high risk.
2. Risk tolerance
Risk tolerance requires the trader to identify their personal tolerance levels for risk. He must determine how much trading risk he will be able to handle without becoming emotional. This insight provides the trader with information on how much of the trade needs to be hedged. One must remember that no trade will ever present with zero risk so it is down to personal preference how much risk you are able to take and remove via hedging.
3. Strategy identification and implementation
When all risks have been analysed and the unwanted excess removed, the hedging strategy will available for testing. One must determine whether the strategy is effective at lowering risk before implementing it. Furthermore, cost-effectiveness must be examined.