If we don’t comprehend the obvious risk there is in hedging the risk we were hoping to avoid using a hedge will be significantly less than the actual losses we may incur. You must therefore know the benefits and drawbacks of hedging.
Meaning
Currency Hedging involves utilizing a strategy by purchasing a foreign exchange option or by directly opening a position in order to protect you against unprofitable movements in the forex market. Accordingly an investor which we assume has made the correct decision to undertake a long hedge position has protected him from downside risk and an investor which has undertaken the correct decision to undertake a short hedge position will protect himself from upside risk. There are two ways of hedging :
1. Spot contracts: These are the normal types of contracts placed by the retail forex trader on a day to day basis.
2. Option contracts: These give you the right but not the obligation to trade as undersigned on a particular currency pair in the future. This is the most used hedging method due to its long term feature.
Advantages of Hedging
-Hedging using futures and options are very good short-term risk-minimizing strategy for long-term traders and investors.
-Its tools can also be used for locking the profit.
-It can aid during difficult market periods.
-Successful hedging gives the trader protection against commodity price changes, inflation, currency exchange rate changes, interest rate changes, etc.
-It can also save time as the long-term trader is not required to monitor/adjust his portfolio with daily market volatility.
-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.
-Risk and reward are often proportional to one other; thus reducing risk means reducing profits.
-It is not practical for the short term trader. Why? Because the currency market is more volatile and more unpredictable when analyzed from shorter time frames.
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 may be very complex for beginners so it is therefore advisable only for experienced traders with good trading skills.
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.
Knowing The Benefits And Drawbacks Of Hedging System