Hedging is a risk management strategy that mitigates the risk of loss due to price fluctuations by offsetting against it. It is especially common when trading instruments that experience [volatile] price movements and that are heavily influenced by dynamic market conditions.
The simplest means of defining what hedging involves is to say that when a trader seeks to limit their exposure on a potentially volatile trade, they will open further trades that are likely to provide a profit that can be used to offset against potential losses from the riskier trade, reducing the risk to the trader of making large losses overall.
Take the opposite position
Let’s assume a trader went into a buy position with expectations of higher prices. They may look to enter a trade on the sell side so that in case the market turns on them, they will make a profit from their sell position, limiting their losses from the buy position.
Options and futures
A [option] gives the holder the option to buy an instrument from the seller at a predetermined price on a date in the future. [futures] are similar to options, but rather than giving the buyer the option to trade, a futures contract makes it an obligation.
Because of their flexibility, options are the preferred method as part of a hedging strategy. Providing the trader with the opportunity to limit their exposure by only buying the option rather than the full order upfront.
Multiple currency trades
This involves taking opposite positions on two currency pairs that are [positively correlated]. For example, the AUD/USD and the GBP/USD share a positive correlation. Therefore, a trader could take a buy position on the AUD/USD and hedge against potential losses by taking a sell position on the GBP/USD. This would mean that should there be a decline in the price of their AUD/USD position, there would also potentially be a similar decline in the GBP/USD position. However, while they would be losing money on the AUD/USD, they would be making a profit on the GBP/USD, and subsequently, reducing their overall losses.
Key takeaways:
- Hedging is a method that is used in risk management strategies as protective insurance against potential losses on riskier trades
- Hedging serves a dual purpose and should be approached with care. As much as it protects against losses, it can also reduce possible profits
- There are three common methods of hedging, opposing positions, options and futures contracts, and multiple currency trades