Hedging strategy simply reduces losses by opening one or more currency transactions that offset existing positions. The primary purpose of hedging is not necessary to completely eliminate your risk. Its main goal is to limit it to a known range.
Individual investors, portfolio managers, and companies use hedging strategies to reduce the various risks they face. However, in the financial markets, it is not as simple as paying insurance companies every year.
The foreign exchange market is the largest and most liquid market globally, which makes it highly volatile. Although this volatility is generally regarded as a recognized part of the foreign exchange trading experience, various hedging strategies can be used to reduce the level of currency risk associated with each position.
The currency risks that Forex hedging can prevent include changes in inflation levels, interest rates, and unexpected news.
How does hedging work in foreign exchange?
These techniques usually involve the use of financial instruments called derivatives. The two most widely known derivatives are options and futures. Using derivatives, you can develop a trading strategy in which the gains of the derivatives offset the loss of investment.
Imagine you own Tesla stock. Although you have believed in the company for a long time, you are worried about some short-term losses in the electric vehicle industry. You can buy a put option on the company that will protect you from the Tesla stock’s fall. It gives you the right to sell Tesla stock at a specific price. This strategy has its name- a married put option. If your stock price falls below the strike price, these losses will be offset by the gain from the put option.
Another classic hedging example involves a company that relies on a specific commodity. Suppose Tesla is concerned about fluctuations in the price of electric vehicles. If the price of agave soars, the company will be in trouble because it will seriously affect their profits.
To prevent uncertainty in the price of these vehicles, Tesla can sign a futures contract.
A futures contract is a hedging tool allowing a company to buy or give at a specific price on a particular date in the future. Now, Tesla can budget without worrying about fluctuations in electric vehicle prices.
If the electric vehicle price soars above the price specified in the futures contract, this hedging strategy will pay off because Tesla will save money by paying a lower price. However, if the price drops, Tesla is still obliged to pay the price in the contract. Therefore, they shouldn’t hedge this risk.
Because of the vast variety of options and futures contracts, investors can hedge almost anything, including stocks, commodities, interest rates, or currencies.
Downsides of hedging
Every hedging strategy has costs associated with it. Therefore, before you decide to use hedging, you should ask yourself whether the potential benefits are sufficient to justify the cost. Remember, the purpose of hedging is not to make money; it is to avoid losses. The cost of hedging, whether the cost of options or the loss of profits caused by the wrong side of the futures contract, can be avoided.
Although it is tempting to compare hedging to insurance, insurance is much more precise. With insurance, your loss will be fully compensated (usually minus the deductible). Hedging portfolios is not a perfect science. Things are easy to go wrong. Although risk managers always aim for ideal hedging, it is difficult to achieve in practice.
Risk is an essential but unstable factor in investment. No matter what type of investment a person targets, mastering the basic knowledge of hedging strategies will help to understand better how investors and companies protect themselves.
Whether you decide to start practicing the complex uses of derivatives, understanding how hedging works will help you deepen your knowledge of the market, which will always help you become a better investor.