- Forex hedging can reduce your FX riskexchange fluctuations image by Raimundas from Fotolia.com
Forex market, also known as FX or foreign exchange market, is the world's largest financial market, with daily turnover of more than $1.5 trillion. Forex marker is dominated by commercial and investment banks, mutual funds, hedge funds, and large multinational companies. Market participants trade currency for different reasons: some need to convert their cash flows from or into foreign currencies; others buy and sell FX instruments purely for speculative purposes. Whatever your objective for trading foreign exchange, there are certain guidelines that can help you reduce your risks, or, in other words, hedge your positions.
Inversely Correlated Currency Pairs
- The primary risk in foreign exchange is the fact that exchange rates move. It is often difficult to predict which way an exchange rate will go. However, some currency pairs exhibit a strong direct or inversed correlation (direct correlation occurs when two variable rise and fall in concert with each other; inversed correlation is when one falls and another rises).
You can easily identify currency pairs with inversed correlation looking at a 1-Day chart. For example if, EUR/USD rises, USD/CHF falls. Then, if you buy both currencies, your position will be hedged to a certain degree (you will still be exposed to the risk of the EUR/CHF cross declining).
- A more certain, but more expensive, way to hedge your Forex risk is to buy options. An option is a financial instrument that gives the buyer the right but not the opportunity to buy a given currency at a certain price (strike price) by a certain date in the future (the option's maturity).
Options constitute the safest, although most expensive, hedge against FX risks.
- Another way to hedge your exposure is to buy or sell (go short) instruments that are inversely correlated with the FX instruments in your portfolio. Those instruments could be stock indices, community futures, gold or bonds. Buying those instruments will help you offset any potential losses on your FX position.
Work With Multiple Brokers
- Another kind of risk that exists in the Forex market is the so-called brokerage risk. Especially after the bankruptcy of Lehman Brothers in September 2008, investors have become more aware of this risk. Essentially it goes down to the possibility of your prime broker going bust, and you losing your deposit as a result. To prevent getting in such an undesirable situation, trade with multiple brokers, so even if one fails, you will still have your funds available at the others.