Hedging with currency Trading

Hedging with currency Trading

Hedging is a way of reducing some of the risk involved in holding an open position. There are many different circumstances in which a trader might wish to hedge. When someone mentions hedging, think of risk protection. A hedge is just a way of insuring an investment against risk.

Much of the risk in holding any currency position is market risk; i.e. if the market falls sharply, your losses may escalate dramatically. So if you have an open currency position with good prospects but you think the currency pair may reverse against you, you may be well advised to hedge your position.
Hedging in currency vs. Equities

Hedging in currency is much easier than other equity markets. In stocks, the simplest, but most expensive method is to buy a put option for the stock you own. (It's most expensive because you're buying insurance not only against market risk but against the risk of the specific security as well.) You can buy a put option on the market (like an OEX put) which will cover general market declines. You can also hedge by selling financial futures (e.g. the S&P 500 futures). Selling covered calls on your stocks is another option. However, in this case, you won't be completely covered.

You may also hedge in the equity markets by selling short the stock of a competitor to the company whose stock you hold. For example, if you like Microsoft and think they will eat Borland's lunch, buy MSFT and short BORL. No matter which way the market as a whole goes, the offsetting positions hedge away the market risk. You make money as long as you're right about the relative competitive positions of the two companies.

Heding in currency is a much simpler task. To demonstrate, let's take a trader who is long the GBP/USD on the first Thursday of the month. Because the trader is experienced, he or she is aware that the Non-Farm payroll is released the first Friday of each month. The trader's position is long term and he or she is worried that the market may move wildly. Because of the nature of currency, there is no long bias to the market, meaning that a trader may open long and short positions just as easily. To hedge the position and eliminate the risk of the economic release, the trader simply needs to open as many short GBP/USD positions as they currently have long. The trader has hedged their position and limited risk immediately.