In broad terms, the hedging is a kind of insurance that a trader often wants to ensure in case of a negative event taking place in the financial market. You can’t stop a negative event from taking place in the market but when you hedge yourself, you somehow try to reduce the negative impact on your financial prospects. Hedging can be witnessed commonly in the field of insurance, and its objective is to protect you from the negative consequences in unforeseen disasters such as fires, floods, earthquakes or break-ins.
Many investors use a host of hedging techniques to reduce the impacts of negative events in the market. It means, investors can strategically use instruments to offset the consequences of adverse market movements. In financial markets, an investor can pay a fee every year to an insurance company to hedge against investment risk. This means, an investor can make one investment to help protect another investment.
Technically, hedging can be possible in case of trading any financial instrument and can be possible in case of trading multiple currencies. Suppose you are investing in EUR/USD currency pair with an intention of making profit.
Now for hedging your EUR/USD investment, you may invest in a related currency pair, say GBP/USD. If the one investment goes against you, the other currency pair may compensate your losses, and in this manner, the Forex hedging takes place. Thus, for Forex hedging, you will invest in two currency pairs with negative correlations.
In the Forex market, however, a trader can use derivatives for hedging instead of using the full-priced trading instrument. If a trader uses a leverage of 100 to 1, it means the trader can enjoy a hedge protection where he needs to pay a cost of 1% to insure the amount invested in the Forex market.
Although hedging is a useful technique, but many Forex investors might never use it. However, a trader should learn about it and must be aware of few important things about Forex hedging. It’s a way of minimizing losses but one should not hedge too often, as it can reduce earning prospects in the long run.
Another important thing is that hedging always involves a cost, particularly when the price movement is in the adverse direction. Most traders more commonly use hedging opportunities when a currency moves in the negative direction in the Forex market.