Key aspects of hedging
Today, the concept of hedging is inextricably linked to dealing. The term itself comes from the English word hedge, which means "to limit".
The technique is intended to reduce losses by balancing the aggregate position, but in practice things are not quite simple. Any hedging is impossible without a systematic approach and strict discipline.
By hedging, we mean covering exchange risks by means of foreign trade or any other credit operations, aimed at changing the price of an asset.
Moreover, these transactions are not speculative. They are focused solely on building up an insurance reserve to compensate for unforeseen financial losses due to the influence of unfavorable factors on the quotes in question.
In a general sense, there is a reduction of loss from an exchange-traded (sometimes over-the-counter) instrument as a result of investing in another asset.
Reducing risk through hedging
The use of hedging is always problematic. A trader is compelled to open a position which in the expected circumstances he would never have opened. Therefore it is always a good idea to analyze the open positions and the current market situation before you introduce a hedge, and only then resort to the most effective forex hedging strategy.
Otherwise, hedging will generate a lot of additional problems.
Forex hedging peculiarities
One has to be particularly careful at the insurance stage directly in the FOREX market.
The fact is that all leading currencies are quite correlated or interrelated. The structure of the modern currency system is represented in such a way, that in the interbank market all trading is done against USD. The USD is a universal instrument, a safe haven currency and an investment during complicated political and financial crises around the world.
Even in the midst of the American crisis the strength of the US dollar as the world's leading currency is still intact.
Once you have decided about opening a hedge operation, you should start choosing an instrument.
Here it is appropriate to remember that the purpose of hedging is to minimise risk, and the purpose of arbitrage is to make a profit.
Consequently, at the same time the hedger is trying to reduce his losses, and the speculator knowingly exposes himself to danger, exacerbates the situation and escalates the profit factor. This is why one can sometimes observe sharp spikes in the currency charts during the release of important economic news.
Nevertheless all hedging instruments are divided into the on-exchange and over-the-counter assets according to the way they are traded.
OTC assets include commodity swaps and forward contracts. Such transactions are carried out directly between participants or with the help of a swap dealer.
Exchange-traded hedging instruments include commodity futures and related options. In this version, trading takes place on the exchange floors themselves, and the exchange clearing house is one of the parties to the transaction. It also acts as the guarantor of all obligations, both of buyers and sellers.
An important prerequisite for the existence of a sales institution is the standardisation of exchange-traded commodities. These include crude oil and basic oil products, natural gas, base and precious metals, and all kinds of foodstuffs.
Initially, the hedging mechanism originated from the reciprocal movement of the price of a commodity in the spot market and a similar futures contract, which made it possible for futures contracts to compensate for losses incurred by trading the real products.
Over time, the term acquired a broader meaning, and hedging transactions could be successfully combined with other risky operations, particularly in the FOREX market.
And yet, the main purpose of hedging is not to make a profit, but to mitigate the risk of unforeseen losses. You always have to pay for reliable insurance.
In addition to the psychological costs, hedging requires the presence of margin, commissions, the costs of bid-ask spreads and Swap charges, as well as the presence of variation margin.
Thus, before hedging, it is necessary to estimate the level of possible losses of all open positions and the cost of potential insurance. Only if there is a clear benefit from the hedging strategy does it become a condition for its positive use.