Hedge
What is hedging?
Hedging (from English hedge - insurance, guarantee) - the use of one financial instrument to reduce the risk associated with the negative impact of market factors on the price of another related instrument.
In simple words, hedging is. reimbursement of losses from one transaction by the profit received from another transaction.
What is the essence of risk hedging?
Most often the term "hedging" is used to define the insurance of financial risk (changes in the price of an asset, interest rate or exchange rate) by means of derivative instruments - standardized derivative contacts, futures or options. However, other examples of paired instruments are not excluded.
The hedging mechanism is to create a balance between liabilities in the cash market (commodities, securities, currency) and the futures market. For example, in order to protect against financial losses, a counterparty position can be opened for a selected instrument, which can compensate for losses in case of unfavorable circumstances.
What is the purpose of hedging currency risks?
The purpose of hedging is not to make a profit. Its main objective is to reduce losses resulting from unforeseen movements in exchange rates.
In the market, currency hedging can be used for three purposes:
- Reducing the risk of a possible loss on the main position;
- Withdrawal of unprofitable position in Breakeven;
- Receive income on one or both positions at once.
What are the different hedging techniques and instruments?
Today, the most popular instrument for hedging financial risks in the derivatives market is futures, which are used for full and partial hedging, as well as for other strategies.
The most common hedging strategies on are:
- Opening two positions in different directions and with the same lots for two unidirectional currency pairs.
- Opening two positions in the same direction with the same lots, on two differently directed currency pairs.
What should be considered when hedging on ?
When hedging currency risks, it is imperative to consider:
- The difference in the movement of currency pairs
To hedge a losing pair, it is necessary to find another currency pair that has strong positive or negative correlation. That is, a pair that either goes exactly the same way as the pair on which you have an open trade, or a pair that goes exactly the opposite (mirror);
- Speed differential
The second pair, on which the opposite trade is opened (if they are unidirectional) or a trade in the same direction (if the pairs are multidirectional) - must be faster than the first one. In order to bring profit, the pair should have time to pass a greater distance and cover the formed loss or bring profit;
- Difference in cost per item
In hedging, there is one major currency pair and a minor currency pair on which the trader simply hedges the risk. It is advisable to choose a major currency pair that has a higher cost per pip;
- Using a pair without a weak currency
Depending on which currency gives drawdown in a pair, it is necessary to choose a currency pair in which there is no losing currency or open an opposite deal on a unidirectional (with positive correlation) pair.
- It is necessary to open a deal with equal volume
If you opened a losing trade with 1 lot volume, then you should open a second trade with the same volume. In no case should you open trades in large volumes in the hope of quickly recouping the loss and making a profit;
- Swap accounting (rollover of a position to the next day)
Because in the end, in a week or more while the trade is open, a decent minus or on the contrary a decent plus may be added, which will help you to get out of a bad trade sooner.