Whether you’re a large corporation or just a sole proprietor, you should strive to understand coverage. Hedging is done through the use of market instruments that can offset the risk of any negative movement in price.
You’ll find hedging to be a bit of a mystery, although it’s a popular business term in many industries. He must consider it as a type of insurance plan. This is because you are insuring yourself against unforeseen events that occur when you hedge your Forex trades.
However, you must realize that if a negative event occurs, your Forex trading could still be affected to one degree or another. You just won’t take as much of a hit if you’ve hedged your Forex positions properly. That is, you have contracted the equivalent of a type of common insurance in case the worst happens.
You will find that this is easier to do by hedging one investment against a similar one. For example, most Forex traders achieve this by using ‘correlation’ and offsetting one currency pair against another suitable one.
For example, if you decide to buy EUR/USD, you will certainly make a stop to protect your account. However, you can still provide additional protection by opening a short position in EUR/JPY. So, if the euro falls unexpectedly and not as planned, at least the drop in EUR/JPY might provide you with some compensation.
However, before you load and use this more sophisticated method of stopping, you should be aware of the following pitfall.
Basically, in this example, you would have opened a position in EUR/USD and sold one in EUR/JPY to hedge the up and down movements of the Euro. However, you still would not be hedging if the USD rose against the EUR while the EUR rose against the JPY.
To overcome this problem, you will need to open a third position and buy USD/JPY. Your three trades will now cover all buy and sell combinations of all three currencies.
As you can imagine, this position can get quite complex and is one of the downsides of using currency correlation as a hedging method.
Consequently, you will need to make sure that the benefits you get from coverage are worth your time and effort. You should also assess that your financial outlay to cover your hedge is made in such a way as to provide you with a sufficient reduction in your Forex risk exposure.
You should always remember that you are using hedging as a method of protecting your losses and it is not designed to produce large profits for you. Although your losses cannot be completely avoided, your coverage should cushion any negative impact. In addition, you should be aware that correlated coverage may incur costs for you even if it is not activated.