To perform a Forex hedge is bit different than hedging in commodities. The similarities, of course, is in the term, ‘hedge’. Any time someone hedges, they are taking the equal and opposite position to either minimize their loss or protect their profits. It’s all the same whether it is a Forex hedge, or commodities, or a weekend football game.
The difference in a Forex hedge is that, while protecting yourself with one particular currency, you may wind up exposing yourself on a couple other levels. The Forex trader has to be careful that while trying to protect himself from sustaining a large loss he doesn’t open himself to that exact same potential.
Dealing with pairs
In the example of commodities and that weekend football game, hedging your bet or your investment will in most cases result in the minimization of a loss. In all cases of hedging including the Forex hedge the trader should understand that, while minimizing his loss he is also going to minimize the gain if the market goes his way. Because of the fact that you’re buying and selling the same thing, whether it is currency of any other thing, you have already offset one position.
In Forex, the trader buys and sells currency pairs. For obvious reasons, no two pairs are alike. So, if a trader wants to protect himself from the plummeting US dollar against the Japanese yen, he might want to do so by taking a reverse position coupled with the Euro. That way the loss in the US dollar has been stemmed and he’s still in the market by using the Forex hedge.
When looked at in this format, it is easy to see where the double risk might come in. While protecting himself in the movement of the US dollar, the Forex trader has exposed himself to potential losses in two other currencies where before the Forex hedge, he was only exposed to one other currency other than the US dollar. Currencies don’t always move in concert with each other, which makes the Forex hedge a little trickier.
Better safe than sorry
Particularly for the novice trader, the concept of the Forex hedge is frowned upon. While trying to save yourself in one currency, the exposure to losses in two other currencies is usually too great. The popular advice is to admit you’re wrong; get out; try again. It can tend to get too confusing too quick. When a Forex trader finds it hard to admit he’s wrong about a certain trade and tries to offset it by using another trade, it causes some very bad trading discipline.
There is the other side of the coin, of course. There are times when the Forex hedge is used successfully and the trader may be able to protect his profits and/or limit his loss. It can even work out on all sides of the trade. As mentioned before, there are times when the currencies will act independently of each other and the Forex trader could wind up on the right side of all currencies involved. Except the one he has both bought and sold, of course. It could happen and has been known to happen. But like everything else in trading Forex, you want to go with the odds; and although the theory behind it is sound, in practice it is precarious.
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