Forex for a trader
Hedge definition forex

Hedge definition forexHedge funds are managed portfolios aimed to generate high returns by using aggressive investment strategies. Hedge funds, despite the misleading name, aims to get the biggest bang for an investor’s money. It engages in practically any investment instrument in the foreign exchange market, from spot to futures to swaps. According to a statistical survey done by Greenwich Associates, Hedge funds account for around 20% of the global volume traded in currency trading. In fact, hedge funds are considered as the primary driver of growth in currency trading volumes. To give you an idea on how fast the hedge fund industry is growing, here are some numbers. Twenty years ago, there were only around a hundred hedge funds with about forty billion dollars in assets. In the last few years, however, the hedge fund industry just blew up. Now, the total number of hedge funds under management has risen to more than 10,000 with assets amounting to almost 1.5 trillion dollars. Some say that hedge funds are so powerful that they could overpower currency intervention practices of central banks. If you’re looking for additional reading to supplement your forex trading education, you’ve come to the. Investment management firms manage financial assets and funds of other institutions.

They use the currency. Currency intervention occurs when one central bank or more buys (or sells) a currency in the foreign. Industrial Production and Capacity Utilization (IPCU) is a measure of economic activity, released on a. A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge. Lack of Wall St Back-Office Deters Mainstream Crypto Investments. Mundane back-office concerns are giving pause to potential investors in digital currency hedge funds. Investors Seek Cover As Trade Battles Rattle World Markets. Investors have sharply increased their use of hedging strategies, signaling concerns that the intensifying trade battle. Bitcoin Tops $11,000, But Fades After Sharp Rally.

Bitcoin zoomed past $11,000 to hit a record high for the sixth day in a row on Wednesday after gaining more than $1,000 in just 12 hours, stoking concerns that a rapidly swelling bubble could be set to burst in spectacular fashion. Top Market Movers of the Week (Sept. 25-29, 2017) NZD and AUD bashing were major themes this week. But did you also know that CHF strength was also a major theme as well? Hedge definition forex. HEDGING FOREX. HEDGERS - FX RISK EXPOSURE BANKS Banks who deal internationally have inherent risk exposure to foreign currencies, often in multiple ways including trading vehicles. Placing a currency hedge can help to manage foreign exchange rate risk. COMMERCIAL ENTITIES Both large and small commercial entities who conduct international business also have risk exposure to foreign currencies. Selling in foreign currencies and accepting foreign exchange rate risk are often a function of day-to-day business and can help commercials stay competitive. RETAIL INVESTORS Retail foreign currency traders use foreign currency hedging to protect open positions against adverse moves in foreign currency rates. Placing a currency hedge can help to manage foreign exchange rate risk. WHY HEDGE FX RISK EXPOSURE International commerce has rapidly increased as the internet has provided a new and more transparent marketplace for individuals and entities alike to conduct international business and trading activities. Significant changes in the international economic and political landscape have led to uncertainty regarding the direction of foreign exchange rates.

This uncertainty leads to volatility and the need for an effective vehicle to hedge foreign exchange rate risk andor interest rate changes while, at the same time, effectively ensuring a future financial position. Foreign Exchange Rate Risk Exposure Foreign exchange rate risk exposure is common to most almost all conducting international business andor trading. Buying andor selling of goods or services denominated in foreign currencies can immediately expose you to foreign exchange rate risk. If a firm price is quoted ahead of time for a contract using a foreign exchange rate that is deemed appropriate at the time the quote is given, the foreign exchange rate quote may not necessarily be appropriate at the time of the actual agreement or performance of the contract. Placing a foreign exchange hedge can help to manage this foreign exchange rate risk. Interest Rate Risk Exposure Interest rate exposure refers to the interest rate differential between the two countries' currencies in a foreign exchange contract. The interest rate differential is also roughly equal to the "carry" cost paid to hedge a forward or futures contract. As a side note, arbitragers are investors that take advantage when interest rate differentials between the foreign exchange spot rate and either the forward or futures contract are either too high or too low. In simplest terms, an arbitrager may sell when the carry cost he or she can collect is at a premium to the actual carry cost of the contract sold. Conversely, an arbitrager may buy when the carry cost he or she may pay is less than the actual carry cost of the contract bought. Either way, the arbitrager is looking to benefit from a small price discrepancy due to interest rate differentials. Foreign Investment Stock Exposure Foreign investing is considered by many investors as a way to either diversify an investment portfolio or seek a larger return on investment(s) in an economy believed to be growing at a faster pace than investment(s) in the respective domestic economy. Investing in foreign stocks automatically exposes the investor to foreign exchange rate risk and speculative risk. For example, an investor buys a particular amount of foreign currency (in exchange for domestic currency) in order to purchase shares of a foreign stock. The investor is automatically exposed to two separate risks. First, the stock price may go either up or down and the investor is exposed to the speculative stock price risk.

Secondly, the investor is exposed to foreign exchange rate risk because the foreign exchange rate may either appreciate or depreciate from the time the investor first purchased the foreign stock and the time the investor decides to exit the position and repatriate the currency (exchanges the foreign currency back to domestic currency). Therefore, even if a speculative gain is achieved because the foreign stock price rose, the investor could actually lose money if devaluation of the foreign currency occurred while the investor was holding the foreign stock (and the devaluation amount was greater than the speculative gain). Placing a foreign exchange hedge can help to manage this foreign exchange rate risk. Hedging Speculative Positions Foreign currency traders utilize foreign exchange hedging to protect open positions against adverse moves in foreign exchange rates, and placing a foreign exchange hedge can help to manage foreign exchange rate risk. Speculative positions can be hedged via a number of foreign exchange hedging vehicles that can be used either alone or in combination to create entirely new foreign exchange hedging strategies. FX HEDGING VEHICLES Below are some of the most common types of foreign currency hedging vehicles used in today's markets as a foreign currency hedge. Retail forex traders typically use foreign currency options as a forex hedging vehicle. Banks and commercials are more likely to use forwards, options, swaps, swaptions and other more complex derivatives to meet their specific forex hedging needs. Spot Contracts A foreign currency contract to buy or sell at the current foreign currency rate, requiring settlement within two days. As a foreign currency hedging vehicle, due to the short-term settlement date, spot contracts are not appropriate for many foreign currency hedging and trading strategies. Foreign currency spot contracts are more commonly used in combination with other types of foreign currency hedging vehicles when implementing a foreign currency hedging strategy. For retail investors, in particular, the spot contract and its associated risk are often the underlying reason that a foreign currency hedge must be placed.

The spot contract is more often a part of the reason to hedge foreign currency risk exposure rather than the foreign currency hedging solution. Option Contracts A financial foreign currency contract giving the buyer the right, but not the obligation, to purchase or sell a specific foreign currency contract (the underlying) at a specific price (the strike price) on or before a specific date (the expiration date). The amount the foreign currency option buyer pays to the foreign currency option seller for the foreign currency option contract rights is called the option "premium." A foreign currency option can be used as a foreign currency hedge for an open position in the foreign currency spot market. Interest Rate Options A financial interest rate contract giving the buyer the right, but not the obligation, to purchase or sell a specific interest rate contract (the underlying) at a specific price (the strike price) on or before a specific date (the expiration date). The amount the interest rate option buyer pays to the interest rate option seller for the foreign currency option contract rights is called the option "premium." Hedging currency risk exposure with interest rate option contracts are more often used by interest rate speculators, commercials and banks rather than by retail forex traders as a foreign currency hedging vehicle. Interest Rate Swaps A financial interest rate contracts whereby the buyer and seller swap interest rate exposure over the term of the contract. The most common swap contract is the fixed-to-float swap whereby the swap buyer receives a floating rate from the swap seller, and the swap seller receives a fixed rate from the swap buyer. Other types of swap include fixed-to-fixed and float-to-float. Interest rate swaps are more often utilized by commercials to re-allocate interest rate risk exposure.

Forwards & Swaps Currency forwards and swaps are more often used by institutions and commercials rather than by retail forex traders. A foreign currency forward is a contract to buy or sell a foreign currency at a fixed rate for delivery on a specified future date or period. Foreign currency forward contracts are used as a foreign currency hedge when an investor has an obligation to either make or take a foreign currency payment at some point in the future. If the date of the foreign currency payment and the last trading date of the foreign currency forwards contract are matched up, the investor has in effect "locked in" the exchange rate payment amount. Foreign currency futures contracts have standard contract sizes, time periods, settlement procedures and are traded on regulated exchanges throughout the world. Foreign currency forwards contracts may have different contract sizes, time periods and settlement procedures than futures contracts. Foreign currency forwards contracts are considered over-the-counter (OTC) due to the fact that there is no centralized trading location and transactions are conducted directly between parties via telephone and online trading platforms at thousands of locations worldwide. A currency swap is a financial foreign currency contract whereby the buyer and seller exchange equal initial principal amounts of two different currencies at the spot rate. The buyer and seller exchange fixed or floating rate interest payments in their respective swapped currencies over the term of the contract. At maturity, the principal amount is effectively re-swapped at a predetermined exchange rate so that the parties end up with their original currencies. FX HEDGING COSTS When hedging forex, virtually all foreign currency hedging vehicles come at some cost. Carrying cost, option premium, margin and hedging PL are all costs that may be associated with hedging forex. However, if you look at the foreign currency hedging cost from the proper perspective, you will most likely realize that the cost to place a forex hedge is relatively small compared to the protection forex hedging can provide. On the other hand, the whole point of placing a forex hedge is to offset forex market risk exposure at a reasonable cost - if a foreign currency hedging strategy is not cost effective then the investor should explore other options for managing forex market risk.

The cost to place a foreign currency hedge should be taken into account both before the forex hedge is placed, while the hedge is in place and again after the forex hedge is lifted. In theory, a foreign currency hedging strategy will almost always look fairly good on paper before the foreign currency hedge is placed. However, it is only after the foreign currency hedge has been placed and then lifted that the actual effect is realized. There is a learning curve involved in foreign currency hedging, and analysis and modification of the foreign currency hedging strategy are part of the learning process. CONCLUSION Foreign currency hedging, when properly implemented, is a valuable foreign currency risk management tool. However, foreign currency hedging if not properly implemented or supervised, can be catastrophic. When implementing a foreign currency hedging strategy, remember that trading and hedging foreign currency is often an imperfect science. Understand that foreign currency hedging has an inherent associated cost and that there is also a learning curve involved. If you are a retail forex trader who may need trading andor hedging advice every now and then, make sure you have a broker who takes the time to understand your investment objectives and gives you non-biased advice. In finance, a hedge is a strategy intended to protect an investment or portfolio against loss. It usually involves buying securities that move in the opposite direction than the asset being protected.

How it works (Example): Let's assume part of your investment portfolio includes 100 shares of Company XYZ, which manufactures autos. Because the auto industry is cyclical (meaning Company XYZ usually sells more cars and is more profitable during economic booms and sells fewer cars and is less profitable during economic slumps), Company XYZ shares will probably be worth less if the economy starts to deteriorate. How do you protect your investment? One way is to buy defensive stocks . These stocks might be from the food, utility, or other industries that sell products that consumers consider basic necessities. During economic slumps, these stocks tend to gain or at least hold their value. Thus, these stocks may gain when your XYZ shares lose. #-ad_banner-#Another way to hedge is to purchase a put option contract on the shares (this would essentially allow you to "lock in" a particular sale price on XYZ, so even if the stock crashed, you wouldn't suffer much). You could also sell a futures contract , promising to sell your stock at a set price at a certain point in the future.

Hedging is like buying insurance. It is protection against unforeseen events, but investors usually hope they never have to use it. Consider why almost everyone buys homeowner's insurance. Because the odds of having one’s house destroyed are relatively small, this may seem like a foolish investment . But our homes are very valuable to us and we would be devastated by their loss. Using options to hedge your portfolio essentially does the same thing. Should a stock or portfolio take an unforeseen turn, holding an option opposite of your position will help to limit your losses. Portfolio hedging is an important technique to learn. Although the calculations can be complex, most investors find that even a reasonable approximation will deliver a satisfactory hedge. Hedging is especially helpful when an investor has experienced an extended period of gains and feels this increase might not be sustainable in the future. Like all investment strategies, hedging requires a little planning before executing a trade.

However, the security that this strategy provides could make it well worth the time and effort. Examples of hedge in a Sentence. the messenger was confronted with a hedge of spears held aloft by the castle guards. Recent Examples of hedge from the Web. These example sentences are selected automatically from various online news sources to reflect current usage of the word 'hedge.' Views expressed in the examples do not represent the opinion of Merriam-Webster or its editors. Send us feedback. Origin and Etymology of hedge. First Known Use: before 12th century. in the meaning defined at sense 1a. Other AgricultureGardening Terms. Examples of hedge in a Sentence. The garden is hedged by flowering shrubs. She hedged when she was asked to support the campaign. He hedged his earlier comments about the need for new management. Recent Examples of hedge from the Web. These example sentences are selected automatically from various online news sources to reflect current usage of the word 'hedge.' Views expressed in the examples do not represent the opinion of Merriam-Webster or its editors.

Send us feedback. Origin and Etymology of hedge. First Known Use: 14th century. in the meaning defined at transitive sense 1. Recent Examples of hedge from the Web. These example sentences are selected automatically from various online news sources to reflect current usage of the word 'hedge.' Views expressed in the examples do not represent the opinion of Merriam-Webster or its editors. Send us feedback. Origin and Etymology of hedge. First Known Use: 14th century. in the meaning defined at sense 1. Other AgricultureGardening Terms. Financial Definition of HEDGE. In finance, a hedge is a strategy intended to protect an investment or portfolio against loss. It usually involves buying securities that move in the opposite direction than the asset being protected. Let's assume part of your investment portfolio includes 100 shares of Company XYZ, which manufactures autos.

Because the auto industry is cyclical (meaning Company XYZ usually sells more cars and is more profitable during economic booms and sells fewer cars and is less profitable during economic slumps), Company XYZ shares will probably be worth less if the economy starts to deteriorate. How do you protect your investment? One way is to buy defensive stocks. These stocks might be from the food, utility, or other industries that sell products that consumers consider basic necessities. During economic slumps, these stocks tend to gain or at least hold their value. Thus, these stocks may gain when your XYZ shares lose. Another way to hedge is to purchase a put option contract on the shares (this would essentially allow you to "lock in" a particular sale price on XYZ, so even if the stock crashed, you wouldn't suffer much). You could also sell a futures contract, promising to sell your stock at a set price at a certain point in the future. Hedging is like buying insurance. It is protection against unforeseen events, but investors usually hope they never have to use it. Consider why almost everyone buys homeowner's insurance. Because the odds of having one’s house destroyed are relatively small, this may seem like a foolish investment. But our homes are very valuable to us and we would be devastated by their loss. Using options to hedge your portfolio essentially does the same thing. Should a stock or portfolio take an unforeseen turn, holding an option opposite of your position will help to limit your losses.

Portfolio hedging is an important technique to learn. Although the calculations can be complex, most investors find that even a reasonable approximation will deliver a satisfactory hedge. Hedging is especially helpful when an investor has experienced an extended period of gains and feels this increase might not be sustainable in the future. Like all investment strategies, hedging requires a little planning before executing a trade. However, the security that this strategy provides could make it well worth the time and effort. What is Currency Hedging? - Definition, Example & Risk. Shelu is a Certified Public Accountant, SAP Business One Consultant, University Professor handling Taxation, Financial Accounting, Cost Accounting and Basic Accounting. Want to watch this again later? Log in or sign up to add this lesson to a Custom Course. What Is Currency Hedging?

Have you ever traveled to a foreign country? If you have, you may remember dealing with the exchange rate , which tells you how much your dollar is worth in euros, pesos, yen, or whatever the foreign currency is. Guess what? Large companies deal with this every day on a massive scale. A change in the exchange rate might have altered how many souvenirs you could buy, but to large companies, a change in the exchange rate can cause catastrophic losses. How can companies handle such huge financial risk? Currency hedging is the use of financial instruments, called derivative contracts, to manage financial risk. It involves the designation of one or more financial instruments as a buffer for potential loss. In hedging, the change in the fair value or cash flows of the derivative will offset, in whole or in part, the change in fair value or cash flows of a hedged item. Imagine running a company in the United States, say MM Corporation; it has a loan of €50,000 with French Bank. Naturally, such a loan is denominated in the French currency, the euro of course. Hence, the company is subject to the risk of fluctuating exchange rate between two different currencies. As part of MM management, you know that when the dollar devalues against the euro, the company will have to pay more in dollars to settle the obligation. On the contrary, should the euro devalue against the dollar, the company will need a lesser amount in terms of US dollars. To manage this risk of paying more upon maturity date, you entered into a foreign currency forward contract with a third party speculator.

On the contract date, the forward contract was set at the current exchange rate. The exchange rate was $1 to €0.93. This means that to settle the loan amounting to €50,000, MM Corporation's payment is pegged at €0.93, or $53,764, regardless of the dollar to euro exchange rate on maturity date. If on the maturity date, the dollar devalues against the euro and the exchange rate is at $1 to €0.90, MM will need more US dollars - $55,556 - to settle the obligation; however, since MM Corporation entered into a foreign currency forward contract, the eventual net cash outflow by MM will only be $53,764, the amount originally pegged. Of course, MM will have to pay French Bank the total amount of $55,556, but the difference of $1,792 will be received by MM from the third party speculator. Conversely, if the euro devalues against the dollar and the exchange rate will be $1 to €1.02, the eventual net cash outflow of MM will still be $53,764. MM will have to pay French Bank $49,020 and MM will have to pay the third party speculator the amount of $4,744. A hedged item is an asset, liability, firm commitment or a net investment in a foreign operation, that exposes the company to the risk of changes in fair value or future cash flows. In our illustration, the hedged item is actually the loan denominated in foreign currency. The derivative contract, or the hedging instrument, is the foreign currency forward contract, and the related risk is the foreign currency risk. In a hedging contract, there are two parties: the company and the third party speculator, usually a bank. Again, the purpose of hedging is to manage financial risk. This risk management strategy will limit or offset the probability of loss due to the fluctuation in the prices of commodities, currencies or securities. In the process, there is transfer of risk without necessarily buying insurance policies. Financial risk may be categorized into four types: What is Hedging? Definition, Examples and Hedging Strategies in Financial Markets. A hedging is designed to protect the value of a share of market volatility. Hedging strategies may include derivatives, short selling and diversification.

Coverage usually involves placing a trade or investment in an asset that moves in the opposite direction of stock prices. Therefore, when the stock price falls, the coverage should increase in value, offsetting the loss. Derivatives, such as options and futures, can be used for hedging purposes. Several strategies of options are available to cover stock positions. For example, a put option contract – that gives the trader the right to sell the underlying stock at a particular price before the expiration date – rises in value if the stock price falls, thus covering the original position. Eric Dash of The New York Times mentioned collars as another option strategy that limits the profit potential both on the upside and the downside risk. Futures Hedging Strategies: Short selling is a hedging strategy involves borrowing a financial instruments and selling it in the hope of buying back later when the price falls. Investors cannot hold long and short positions of the same stock in their portfolios. However, little can stock indexes to cover their equity positions, according to Tom Konrad. For example, an investor holding large Indian stocks could short the Nifty index of protection against a market downturn.

Shorting is simpler index options and there is no expiration date for concern, although there is potential for a strong market up which could result in significant losses. Another hedging strategy is Diversification, which means holding investment positions in companies of various sectors of the industry, is a form of natural hedging. The advantage of diversification is that it acts as a natural hedge, if a population suffers, the entire portfolio does not take a hit. Investors can also invest in stocks that move in opposite directions. For example, David Bogslaw of Business week magazine writes how investors can hedge against inflation – which negatively affects profit margins and stock prices – to invest in assets that keep their values, such as services public, gold and real estate. Goldman Sachs partners and executives from other companies use hedging to protect possible losses on their securities holdings, Dash writes. The concern is that executives might be tempted to take unnecessary risks and losses that are protected on the downside, unlike those of ordinary shareholders. Futures Hedging Examples: The use of futures to hedge stock futures trading involves contracts to provide compensation gain if the market drops significantly. Futures hedging are used to protect the value of a portfolio of large values, a value of Rs. 200,000 or more. Futures trading allows a trader to make financial bets on the future direction of stock indices, with a relatively small investment. Coverage includes the US futures trading to take advantage of falling market values ??shares.

To determine that the index futures traded shares closer you get to the performance characteristics of its portfolio. Futures trading against the following stock indexes: S & P 500, Russell 2000, Dow Jones Industrial Average, NADSAQ 100, S & P 600, S & P Midcap 400, NASDAQ Composite, S & P 500 Growth Index and the S & P 500 Index Value. For a broadly diversified portfolio of stocks, the S & P 500 could be a common choice. A heavy portfolio in technology stocks could be covered by the Nasdaq 100 futures. Open and fund a futures trading account. The futures registered runners are traded on the National Futures Association – NFA – and the Commodity Futures Trading Commission – CFTC. Most brokers do not offer futures trading, and brokers dedicated future will be more useful for new traders’ futures trading. In order to cover the value of your portfolio, one is required to calculate the number of futures contracts. Each futures contract is worth a multiple of the selected stock index. The value of the main futures contracts are 250 times the index value for the S & P 500 index, 50 times the rate in the mini ES & P 500, the Nasdaq 100 100 times and 20 times for the e-mini NASDAQ 100. In 1350 values ??for the S & P 500 and 2,400 for the Nasdaq 100 futures contract each of the four listed would be worth dollar 337,500, 67,500, 240,000 and 48,000 respectively. For example, a USD dollar 200,000 stock portfolio full of technology stocks could be covered with four e-mini NASDAQ 100 futures contracts. Sell ??short the calculated futures contracts in your futures account when you believe the stock will go down number.

Futures trading can be opened with either a purchase or sale; by selling futures to open a trade if the market declines will benefit. A margin deposit for each futures contract locked himself in his futures trading account. Margin for the e-mini Nasdaq 100 is around 10% of contract. E-mini contract will earn for every point that the Nasdaq 100 stock index decreases sold. Close futures positions and lock in profits with purchase orders when you believe that the market has reached the lowest point of the current decline and begin to move in an upward direction. What is a 'Forex Hedge' A forex hedge is a transaction implemented by a forex trader or investor to protect an existing or anticipated position from an unwanted move in exchange rates. By using a forex hedge properly, a trader who is long a foreign currency pair, or expecting to be in the future via a transaction can be protected from downside risk, while the trader who is short a foreign currency pair can protect against upside risk. It is important to remember that a hedge is not a money making strategy. Forex Options Trading. Foreign Exchange Market. BREAKING DOWN 'Forex Hedge' The primary methods of hedging currency trades for the retail forex trader is through spot contracts and foreign currency options. Spot contracts are the run-of-the-mill trades made by retail forex traders. Because spot contracts have a very short-term delivery date (two days), they are not the most effective currency hedging vehicle. In fact, regular spot contracts are often why a hedge is needed.

Foreign currency options are one of the most popular methods of currency hedging. As with options on other types of securities, foreign currency options give the purchaser the right, but not the obligation, to buy or sell the currency pair at a particular exchange rate at some time in the future. Regular options strategies can be employed, such as long straddles, long strangles, and bull or bear spreads, to limit the loss potential of a given trade. (See also: Getting Started In Forex Options ) For example, if a U. S. company was scheduled to repatriate some profits earned in Europe it could hedge some, or part of the expected profits through an option. Because the scheduled transaction would be to sell euro and buy U. S. dollars, the company would buy a put option to sell euro. By buying the put option the company would be locking in an 'at-worst' rate for its upcoming transaction, which would be the strike price. And if the currency is above the strike price at expiry then the company would not exercise the option and do the transaction in the open market. Not all retail forex brokers allow for hedging within their platforms. Be sure to research the broker you use before beginning to trade.

What is hedging as it relates to forex trading? Hedging is a strategy to protect one's position from an adverse move in a currency pair. Forex traders can be referring to one of two related strategies when they engage in hedging. A forex trader can create a “hedge” to fully protect an existing position from an undesirable move in the currency pair by holding both a short and a long position simultaneously on the same currency pair. This version of a hedging strategy is referred to as a “perfect hedge” because it eliminates all of the risk (and therefore all of the potential profit) associated with the trade while the hedge is active. Although this trade setup may sound bizarre because the two opposing positions simply offset each other, it is more common than you might think. Oftentimes this kind of “hedge” arises when a trader is holding a long, or short, position as a long-term trade and incidentally opens a contrary short-term trade to take advantage of a brief market imbalance. Interestingly, forex dealers in the United States do not allow this type of hedging. Instead, they are required to net out the two positions – by treating the contradictory trade as a “close” order. However, the result of a “netted out” trade and a hedged trade is the same.

A forex trader can create a “hedge” to partially protect an existing position from an undesirable move in the currency pair using Forex options. Using forex options to protect a long, or short, position is referred to as an “imperfect hedge” because the strategy only eliminates some of the risk (and therefore only some of the potential profit) associated with the trade. To create an imperfect hedge, a trader who is long a currency pair, can buy put option contracts to reduce her downside risk, while a trader who is short a currency pair, can buy call options contracts to reduce her upside risk. Imperfect Downside Risk Hedges: Put options contracts give the buyer the right, but not the obligation, to sell a currency pair at a specified price (strike price) on, or before, a pre-determined date (expiration date) to the options seller in exchange for the payment of an upfront premium. For instance, imagine a forex trader is long the EURUSD at 1.2575, anticipating the pair is going to move higher, but is also concerned the currency pair may move lower if the upcoming economic announcement turns out to be bearish. She could hedge a portion of her risk by buying a put option contract with a strike price somewhere below the current exchange rate, like 1.2550, and an expiration date sometime after the economic announcement. If the announcement comes and goes, and the EURUSD doesn’t move lower, the trader is able to hold onto her long EURUSD trade, making greater and greater profits the higher it goes, but it did cost her the premium she paid for the put option contract. However, if the announcement comes and goes, and the EURUSD starts moving lower, the trader doesn’t have to worry as much about the bearish move because she knows she has limited her risk to the distance between the value of the pair when she bought the options contract and the strike price of the option, or 25 pips in this instance (1.2575 – 1.2550 = 0.0025), plus the premium she paid for the options contract. Even if the EURUSD dropped all the way to 1.2450, she can’t lose any more than 25 pips, plus the premium, because she can sell her long EURUSD position to the put option seller for the strike price of 1.2550, regardless of what the market price for the pair is at the time. Imperfect Upside Risk Hedges. Call options contracts give the buyer the right, but not the obligation, to buy a currency pair at a specified price (strike price) on, or before, a pre-determined date (expiration date) from the options seller in exchange for the payment of an upfront premium. For instance, imagine a forex trader is short the GBPUSD at 1.4225, anticipating the pair is going to move lower, but is also concerned the currency pair may move higher if the upcoming Parliamentary vote turns out to be bullish. She could hedge a portion of her risk by buying a call option contract with a strike price somewhere above the current exchange rate, like 1.4275, and an expiration date sometime after the scheduled vote. If the vote comes and goes, and the GBPUSD doesn’t move higher, the trader is able to hold onto her short GBPUSD trade, making greater and greater profits the lower it goes, and all it cost her was the premium she paid for the call option contract.

However, if the vote comes and goes, and the GBPUSD starts moving higher, the trader doesn’t have to worry about the bullish move because she knows she has limited her risk to the distance between the value of the pair when she bought the options contract and the strike price of the option, or 50 pips in this instance (1.4275 – 1.4225 = 0.0050), plus the premium she paid for the options contract. Even if the GBPUSD climbed all the way to 1.4375, she can’t lose any more than 50 pips, plus the premium, because she can buy the pair to cover her short GBPUSD position from the call option seller at the strike price of 1.4275, regardless of what the market price for the pair is at the time. Want to thank TFD for its existence? Tell a friend about us, add a link to this page, or visit the webmaster's page for free fun content. Link to this page: Terms of Use Privacy policy Feedback Advertise with Us Copyright © 2003-2018 Farlex, Inc. All content on this website, including dictionary, thesaurus, literature, geography, and other reference data is for informational purposes only. This information should not be considered complete, up to date, and is not intended to be used in place of a visit, consultation, or advice of a legal, medical, or any other professional. In finance, a hedge is a strategy intended to protect an investment or portfolio against loss. It usually involves buying securities that move in the opposite direction than the asset being protected. How it works (Example): Let's assume part of your investment portfolio includes 100 shares of Company XYZ, which manufactures autos. Because the auto industry is cyclical (meaning Company XYZ usually sells more cars and is more profitable during economic booms and sells fewer cars and is less profitable during economic slumps), Company XYZ shares will probably be worth less if the economy starts to deteriorate.

How do you protect your investment? One way is to buy defensive stocks . These stocks might be from the food, utility, or other industries that sell products that consumers consider basic necessities. During economic slumps, these stocks tend to gain or at least hold their value. Thus, these stocks may gain when your XYZ shares lose. #-ad_banner-#Another way to hedge is to purchase a put option contract on the shares (this would essentially allow you to "lock in" a particular sale price on XYZ, so even if the stock crashed, you wouldn't suffer much). You could also sell a futures contract , promising to sell your stock at a set price at a certain point in the future. Hedging is like buying insurance. It is protection against unforeseen events, but investors usually hope they never have to use it. Consider why almost everyone buys homeowner's insurance. Because the odds of having one’s house destroyed are relatively small, this may seem like a foolish investment . But our homes are very valuable to us and we would be devastated by their loss. Using options to hedge your portfolio essentially does the same thing.

Should a stock or portfolio take an unforeseen turn, holding an option opposite of your position will help to limit your losses. Portfolio hedging is an important technique to learn. Although the calculations can be complex, most investors find that even a reasonable approximation will deliver a satisfactory hedge. Hedging is especially helpful when an investor has experienced an extended period of gains and feels this increase might not be sustainable in the future. Like all investment strategies, hedging requires a little planning before executing a trade. However, the security that this strategy provides could make it well worth the time and effort.



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