If we don’t understand the significant risk involved in hedging the risk we aim to avoid by entering a hedge may be less than the significant losses we may incur. It is therefore obligatory that you know the pros and cons of the risky strategy that is hedging.
Definition
Hedging involves making use of method which involves buying a FOREX option or directly opening a trade so as to shield you from unwanted movements in the forex market. So an investor which we know has correctly entered a long hedge will protect himself from downside risk and vice versa. There are two methods of undertaking a hedge:
1. Spot Contracts: These are the usual contracts we encounter on a daily basis. Because spot contracts are usually short term they are not the preferred method.
2. Option contracts: These give you the right but not the obligation to trade as undersigned on a particular currency pair in the future. These are the preferred hedging vehicles due to their long term characteristic.
Advantages of Hedging
-Hedging using futures and options are very good short-term risk-minimizing strategy for long-term traders and investors.
-It can be used for capturing profit.
-It can aid during difficult market periods.
-when utilized correctly it can shield you from commodity price changes, interest rate changes, etc
-It is not time-consuming for the long term trader since it doesn’t require daily monitoring.
-It can give you the opportunity to practice complex option strategies to get the best returns.
Disadvantages of Hedging
-It involves cost that can eat up the profit. Therefore care must be taken to ensure the decision is the correct one.
-Decreasing risk usually goes along with a decrease in profits.
-For most short-term traders, e.g.: for a day trader, it is a difficult strategy to follow. Why? Because of increased noise in the market when using shorter timeframes.
If the market is trending then it has little function.
Using hedging may require you use an account of higher category e.g. with a higher account balance.
It is a precise trading strategy and successful hedging requires good trading skills and experience so it is very unadvisable for inexperienced traders and beginners as some strategies (the successful ones) can be very complex to understand and implement.
As with all trading methods, risks are involved. As with any type of investment approach, hedging also has risks that can result in huge losses. Before you embark on any type of strategy, you need to understand its underlying concepts clearly.
In case you are one of those new traders who may want to jumpstart your trading experience, you can now discover and learn everything simply by finding out about the best forex trading strategy just for you.Take a look at Forex Yard review for a great broker suggestion.
