Why Currency Hedging is a Must Know Strategy for Forex Traders
Currency hedging like any hedging is used to protect the trader. Currency hedging protects the trader, because it will help minimize risk of changes in a currency’s exchange rate. There are few methods used when currency hedging. However, all methods used will usually follow a similar process.
1. You would establish the goal you want to achieve with original investment. For example, a trader taking a long position in a certain currency, he or she would want his or her position to increase in value. The buy price of initial investment would increase in a long position. It would be just the opposite for a trader taking a short position in a currency. Trader taking a short position would want position to go below the buy price of his initial investment.
2. You determine what potential losses may occur by being exposed to an unwanted move in a currency’s exchange rate of the original investment. For example, a trader taking a long position in currency would not want their trade to go below the price he brought currency. You would not want your position to lose value. Once again if you took a short position, you would not want it to increase in value.
3. You put in measures to protect against losses to your original investment or you would use currency hedging. By using the previous example, if you were long in position in currency, your protection would be to take a short position in the same currency pair. It should be noted the method of going long in currency pair and then going short in same currency pair is called direct e hedging.
Some brokers will not allow direct hedging therefore, there are other methods used to achieve current hedging. Forex currency options are used. An example of Forex currency option at work is the use of long straddle strategy. When using Forex options, you the trader are not obligated to execute a trade. It is very important aspect to know because you will better understand the execution of the long straddle strategy in regard to currency hedging.
Long Straddle strategy would involve the trader placing a call contract and a put contract on the same currency pair. A call contract allows a trader the right to purchase a currency with another currency at the contracted price. You would use a call contract if you feel your trade will increase in value. You would then place a put contract on the same currency pair. A put contract will give you the trader the right to sell currency for another currency at the contracted price. You would use put contract if you thought the trade would decrease. The trader will only execute the trade that would bring him or her a profit. Traders would use the long straddle strategy when market is highly volatile and they are unsure of the direction of Forex trade would go.
There are many methods for currency hedging and it is important to protect your trade to minimize your losses. You can take a look at the video and see currency hedging at work.
U.S. investors who buy foreign stocks are increasingly looking at currency hedging, a strategy that has had a mixed track record.
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