Understanding Forex Hedge
Published on May 21st, 2015 | by Joan Makai
Forex hedge or hedging is a method used to minimize losses in any currency trade. In order to understand what is hedging, it is necessary to comprehend what is going long and short in forex markets. Both are positions in the market. A trader going long expects one of the currencies in the pair to increase in value with respect to the other. In contrast, the trader going short assumes one of the currencies in the currency pair to decrease in value vis-à-vis the other currency in the pair. Therefore, the trader going long buys the currency pair with intent to sell it when the desired price is achieved. In contrast, the trader going short sells the currency pair with the intention to buy it when it reaches the rock bottom.
The risk associated with the process is, the trader going long may find that the currency does not reach the desired rate, and may, therefore, not earn profits. Likewise, the trader who sells anticipating the money value of dip may actually find that currency gains in the rate. Effectively, he or she too is likely to lose funds.
In forex markets, the most common transactions are spot transactions. Therefore, the trader buys a currency pair, and this currency pair is to be sold in two days. That period is usually insufficient for many traders who want to go long or short on the currency. Therefore, traders use options, which allow them to take positions, with minimal risks.
What Happens in Forex Currency Options?
Options in Forex currency are another variety of derivatives available to forex traders for forex hedging. These give the trader a longer time frame for achieving the desired price or strike price. There are two traders involved in these. One of them is going short on the currency pair, and the other is going along with the same currency pair. The time frame of the option is predefined and referred to as expiry date. An investor or trader has a call on any currency pair if he or she is buying that pair. Conversely, a forex trader has a put on any currency pair if he or she is selling that pair.
How do Currency Options Reduce Risks?
There are strategies such as straddles and strangles associated with options. For example, the investor can choose two positions in straddle on the same currency pair. When he decides to sell at a particular strike rate in future, he can also take a reverse stand by buying at a specific strike rate. Collectively, the two contracts almost cancel any benefit. But it is possible to earn more if one of the two contracts moves rapidly in one direction.
The option is to either buy or sell by the expiry time. It is, however, not obligatory on forex trader to buy or sell by then or even on achieving strike price. In other words, the trader has “option”. Therefore, the buyer may well refuse to absorb losses, and absorb only the loss of option’s purchase price instead.
Hedging in Forex markets is still in nascent stages because derivatives such as options have recently arrived in this market. There may be simple, complex, and multiple currencies hedging contracts, apart from foreign exchange options for reducing losses. Even though the losses with hedging are lower, it is necessary to understand how to play in forex market, because of there are many other factors that increase or decrease the risks, which cannot be mitigated with hedging.