Every day, millions of traders around the world log into the realm of forex trading in pursuit of making a fortune. The size and gravity of this market can be gauged from the fact that about $5 million are traded every day on average, making someone a loser and someone a winner.
But. amongst all the confusion of graphs, analytics, highs-lows, and shifting trends, it is clear that Forex trading is not free of risk, rather it is the most volatile and liquid financial markets out there. This volatility and an element of uncertainty pose significant financial risks to participants for which no apparent insurance comes in mind.
The best defense that a trader can put up is a fundamental understanding of how and why risks are likely to generate and then minimize it with the right protective strategies. Even when trading in relatively stable markets, there is no artificial way to leverage risk, rather the ability to minimize risk by applying smart forex techniques.
Risk management then becomes a fundamental pre-requisite to the success of an aspiring trader. In a market that is riled with uncertainty, the ability to minimize the occurrence of losses is the differentiating factor between scaling fortunes and a lost cause. This is where the concept and, importance and application of hedging comes in.
The Theory Of Forex Hedging
Hedging is a strategy that has developed over time, as more and more smart traders cracked the code of forex trading, and protected their investments from risk. In a simplified nutshell, hedging with forex is a strategy that protects one’s position in a specific currency pair from an adverse trend.
Hedging allows traders to purchase currency pairs and at the same time, put in a different trade selling the same currency pair. Although in this case, the total net profit is zero, the additional financial risk is minimized as an increasing amount of money can be made, while both trades remain open for the market. All you need, then, is the perfect market timing to capitalize.
From a bird’s eye view, hedging is a short-term contingency plan, that shields a worried trader from the onset of risk that comes from news or events that trigger volatility in currency markets.
Understanding Hedging With a Workable Example
Let’s establish a rudimentary hypothetical situation to understand hedging (things might not be this simple when trading in a full-blown forex market). You as a trader, bought a USD/GBP pair, with USD as the base currency, and the opposite GBP/USD pair, with GBP as the base currency.
In this instance, if the market moves in opposition to your first trade, with the GBP losing value against the USD, you have already insured or hedged this loss by buying the opposite pair from the onset, one where the dollar is rising against the pound. The leverage offered by hedging gives every trader the room to analyze the market, and make profits of the first buy by skillfully suspecting the market’s reversal in the favor of the initial trade, and then closing the second one.
What we have established from this example is that hedging is the science of using forex trends to place a trade against yourself. This creates a zero-risk situation where any potential losses that might come your way are transformed into a profitable conflicting trade, thanks to hedging.
Complications While Hedging
To the detriment of traders that are willing to hedge their initial trade, for greater leverage and risk-management, many brokers are starting to ban direct forex hedging strategies, by not allowing them to be used on the same account. To reap the benefits of hedging, aspiring traders can work with the most trustworthy forex brokers that acknowledge the competitive edge of hedging, and allow its practice.
There is also another indirect way of hedging. In this type of hedging, traders use two conflicting currency pairs to hedge the exposure of a specific currency. However, this still poses a slight risk, as any volatility in a currency pair can result in an unbalanced trade, and an accompanying loss.
Forex trading markets are marred by significant risks that become a potential barrier for many traders’ aspirations to become successful. With risk-managing strategies, people have the edge of making more informed decisions, while managing their losses at the same time, and hedging proves beneficial in this regard.