When traders talk about hedging, what they often mean is that they want to limit losses but still keep forex hedging explained potential to make profits. Of course having such an idealized outcome has a hefty price.
Ultimately to achieve the above goal you need to pay someone else to cover your downside risk. In this article I’ll talk about several proven forex hedging strategies. The first section is an introduction to the concept which you can safely skip if you already understand what hedging is all about. The second two sections look at hedging strategies to protect against downside risk. Pair hedging is a strategy which trades correlated instruments in different directions. This is done to even out the return profile. Option hedging limits downside risk by the use of call or put options.
This is as near to a perfect hedge as you can get, but it comes at a price as is explained. Hedging is a way of protecting an investment against losses. Hedging can be used to protect against an adverse price move in an asset that you’re holding. It can also be used to protect against fluctuations in currency exchange rates when an asset is priced in a different currency to your own. Hedging might help you sleep at night. But this peace of mind comes at a cost.
A hedging strategy will have a direct cost. But it can also have an indirect cost in that the hedge itself can restrict your profits. The second rule above is also important. The only sure hedge is not to be in the market in the first place. Simple currency hedging: The basics The most basic form of hedging is where an investor wants to mitigate currency risk. Let’s say a US investor buys a foreign asset that’s denominated in British pounds. For simplicity, let’s assume it’s a company share though keep in mind that the principle is the same for any other kind of assets.
The table below shows the investor’s account position. Without protection the investor faces two risks. The first risk is that the share price falls. The second risk is that the value of the British pound falls against the US dollar. Given the volatile nature of currencies, the movement of exchange rates could easily eliminate any potential profits on the share.