Basic Knowledge of Foreign Exchange - What is Hedge Trading

Foreign Exchange Hedging

If there is an adverse change in the exchange rate and a foreign exchange trader enters the transaction to protect the existing or planned position, then he/she is in a foreign exchange hedging, which can help traders long on foreign currency well avoid the risk of downward exchange rate, if used reasonably.

There are mainly two ways for retail forex traders to carry out hedge tradings:

1. Spot contract;
2. Foreign exchange option.

Spot contract is the most common type of transaction for retail forex traders, however, due to the short delivery date ( 2 days ), it is not the most effective way of currency hedging. Usually, conventional spot contracts are the reason why hedging is needed, but not used for hedging.

Foreign exchange option, as one of the most popular methods of foreign exchange hedging, gives buyers the right, not the obligation, to buy and sell currency pairs at a specified exchange rate at a future time, just like other securities types of options. Common option strategies such as top / bottom straddle portfolio, wide span portfolio, and bear / bull options spreads can be used to reduce potential losses for specific transactions.

Foreign-Exchange Hedging Strategies

Foreign exchange hedging strategies are composed of four parts, including analyzing the risk exposure, risk tolerance, and strategic preferences of foreign exchange traders, which together form a foreign exchange hedge:

1. Risk Analysis: Traders must be able to identify the risks of current or planned positions. Similarly, they also have to be aware of what will happen if this risk is not hedged and determine the level of risk in current foreign exchange market.
2. Determine risk tolerance: At this step, traders determine how much position risk to hedge based on their own levels of risk tolerance. Every transaction has risks, and traders should decide for themselves how much risk they can bear during each trade and how much they are willing to pay to avoid excess risk.
3. Choosing a Hedging Strategy: If foreign exchange option is applied to hedge trading risk, then traders need to choose a most practical strategy.

4. Implementation and supervision strategy: This is to ensure that hedging strategies can be carried out effectively and risks can be minimized.

Foreign exchange market is full of risks and hedging is merely one way to reduce them. Being a trader is all about funding and risk management, while weapons like hedging can also be very helpful.