Recognize Hedging and its Methodology
Forex trading is one business whose profit and loss is determined by the state of the market. Therefore a trader must always monitor the existing market conditions. This is due to market conditions that do not have a static basis which makes traders sometimes in an unfavorable position.
Hedging occurs when a trader aims to protect certain forex price positions or anticipate an unwanted movement. The reason for using this hedging is that it can be protected from downside risks in open long positions and is protected from upside positions in open foreign currency positions.
Hedging itself is a trading technique that is divided into 2 positions namely open long positions and open short positions without a stop loss installed but only the profit target ranges from 30-50 points in order to get profit when there is a swing price, both when the price is bullish and when the price is bearish.
The main method of hedging in forex is a retail trader through spot contracts and foreign currency choices. The spot contract is a type of regular trading made by forex traders. Hedging is not the most appropriate because the spot contract has a short-term delivery date (two days). You could say the spot contract is used because of hedging rather than being used by hedging itself.
Currency choice is one of the most popular hedging methods. This is because the choice of a foreign currency gives the trader the right to buy or sell a currency pair with a certain exchange rate at a future time, but not as a bond. Regular option strategies can be used such as long straddles or bear spreads with the aim of limiting potential losses.
- Analyzing risk exposures – Traders must identify the type of risk that exists whether it is in the current position or in the position to be carried out. This identification aims to determine the high or low risk in the current forex currency market.
- Risk tolerance – This step alone is to determine how much risk the position needs to be hedged. Traders never have zero risk. There are some of them that determine the level of risk that is willing to be taken or they are willing to pay to eliminate excessive risk.
- Determining a forex hedging strategy – a trader must determine which strategy is usually most effective to use if he uses foreign currency. The aim is to reduce the risk of hedging in foreign exchange trading.
- Determining the strategy – By monitoring the trader can ensure that the strategy works as it should so that the risk can be minimized in accordance with the original goal.
Short-term hedging techniques in whole or in part include:
- Hedging uses a futures contract that is a contract that specifies a currency exchange in a certain volume and is settled on a certain date.
- Hedging uses a forward contract, a contract that is carried out by a customer with a bank to sell or buy currency against other currencies in the future at a rate determined at the time of the contract.
- Hedging uses market instruments which involves taking a position in the money market to protect the position of debt or receivables in the future.
- Hedging uses the currency option where options provide the right to buy or sell a particular currency at a certain price in a certain time. This option is for hedging purposes.
Long term hedging
There are 3 techniques for long-term exposure hedge:
- Long forward is a contract designed to accommodate the specific needs of the company. Long forward is very attractive for companies that have signed contracts because they can protect long-term cash flows.
- Swap Curency is an opportunity to exchange one currency with another using a bank as an intermediary for both parties.
- Parellel Loan is a credit that involves exchanging currencies between two parties with an agreement to exchange the currency at a certain rate and date in the future.
Condition 1: currently GBP / USD is 1.5600. Then traders open long positions because they predict that they will rise to 1.56700. A few minutes later GPB / USD actually fell against the prediction to 1.5580. Trader’s buy position loses 20 points.
Condition 2: In order for the loss to not increase, the trader opens a new position that is opposite to the previous one, which is open short positions at the level of 1.5580. If the market goes down to the level of 1.5550 then the trader loses up to 20 points because the position at condition 1 loses 50 points (1.5600 – 1.5580) while the second position gains 30 points (1.5580 – 1.5550).
Condition 2a: If the market rises to be able to reach the level of 1.5620 then the same will lose 20 points because the first position gains 20 points and the second position loses 20 points (1.5620 – 1.5580).
But the 20-point loss-locked condition can be converted into profit with a note that we can unlock the right conditions. Traders must predict where the next direction is, converging or diverging.