Just a few years ago Europeans were quite likely to purchase not one, but a few Apple Macbooks when visiting the States. The reason for acquiring multiple premium products was simple – the euro was relatively strong against US dollar.
However, today there is hardly any difference between the currencies. While such large fluctuations have a limited impact on regular people, businesses do have to protect their interests and make sure they make as much profit as they expected, even if they are paid in a foreign currency. This is where hedging becomes important. It is a technique that is applied to reduce exposure to different kinds of risks.
So, let's get started!
Hedging in finance
Basically, you can encounter different players of the business world using hedging almost everywhere. Whether they are big corporations or individual investors, they use it to minimize risks. Hedging is often compared to insurance, but there is one main distinction between the two: by hedging against investment risks, corporations or individual investors strategically utilize the instruments in the market in order to neutralize any unfavorable movements in price.
While insurance is usually an annual premium paid to safeguard you from an event that may not even occur, when you hedge one investment you are actually making another one. This is the basic financial principle.
Hedging in FX
If you want to know about a practical example of hedging, then we should mention how traders enter into a Forex hedge. There is a short scenario: traders enter a particular trade to protect either already existing or expected positions from an adverse price movements in exchange rates of a certain currencies. In fact, traders that go long can protect themselves from downside risk and traders that go short can protect themselves against the upside risk.
An important task is to define the basic approaches to hedging currency trades, of which there are two: foreign currency options and spot contracts. With foreign currency options, traders get the right to buy or sell the FX pair at a specific exchange rate in the future. In turn, spot contracts are technically an ordinary type of trade that is performed by Forex traders. Spot contracts are less effective than foreign currency options because they have a very short-term delivery date - 2 days to be precise.
To hedge or not to hedge
It will not be an exaggeration to say that hedging is one of the most disputable techniques in trading. There are two camps which almost all traders divide in: those who think that hedging is great, and those who prefer not to use hedging.
Reasons to hedge
Even though hedging in Forex is not usually for earning profit (unless it is about long term gains) but for reducing losses, it can be useful. In what way? Simple, you can lock in your profit or loss without actually closing the position.
But that is not all. Successful hedgers will have additional protection from bearish market periods or economic downturns as such. Therefore, you will have no problem with different currency exchange rate fluctuations, inflation, commodity price volatility and so on.
Reasons not to hedge
However, there is something not to like about hedging. It is not free, but rather costly as it involves investing in 2 securities simultaneously. So you must think whether the benefits justify the expense.
Additionally, it makes you much less flexible as an investor, especially when you need to react to market shifts quickly. Furthermore, hedging is not 100% viable; it is not an insurance policy in the literal and direct sense.
Ban on hedging in US
In 2009, the NFA or National Futures Association implemented a set of rules that led to the banning of hedging in the United States. So if you try to go long and short the same currency pair at the same time - you will end up with no position at all.
So let's discover the reasons for such ban. The NFA outlined two chief concerns about hedging. The first one is that it eliminates any opportunity to profit on the transaction. The other one is that hedging increases the customer's financial costs.
One of the ways hedging increases customer's costs is by doubling the expense of entering and exiting the transactions. In fact, if you hedge you must pay the entire spread twice. Another reason why NFA banned hedging is because it generates significant potential for abuse.
Possible ways to hedge
However, this ban is not absolute - there are ways to get around it. If you want to keep on hedging within US, you must do the following: open two accounts with the same broker or different ones. Then short a currency pair on one of the accounts and long it on another one.
Another issue to consider is that you will have to quickly transfer cash from one account that brings good and steady profit to one where you have serious drawdown. As an alternative, you can simply put more net capital into these new accounts.