Hedging refers to an advanced investing strategy whose principles are quite simple. As hedge funds become more and more popular, so does the practice of hedging.
Weirdly enough though, the concept is still not completely understood by some people who might as well hedge many things daily, which are unrelated to the stock market.
This article is a useful guide on what hedging is as well as what information exists around this practice.
What is a hedge fund?
A forex hedge is an investment that intends to reduce the risk of unpleasant price movements in an instrument. In other words, it is a transaction implemented to safeguard an existing or expected position from an unwanted move in exchange rates. Most of the times, a hedge is made up of an opposite position in a related security.
A wide range of market participants including investors, traders and businesses use forex hedges. When used properly, these people can be protected from downside risk when opening a long position on a currency pair. Likewise, they can protect against upside risk using a forex hedge when they open a short position.
It is important to note that a forex hedge is considered to prevent losses and not to produce revenue. Also, it might remove part of the risk exposure, not all of it, as at some point it might take away the benefits.
What are the risks in hedging?
As mentioned above, hedging involves some risks as well. While it might reduce potential risk, it also takes away potential gains. In simple words, hedging doesn’t come for free.
Hedging is in some way analogous to an insurance policy. For example, if you wanted to protect something you own from the risk of flooding, in other words, to hedge it, you would insure it. You cannot prevent a flood, but you can mitigate the dangers in the event of a flood beforehand.
How does hedging work?
The most widely used way of hedging in the world of forex is through derivatives. Derivatives refer to securities that move in accordance with one or more underlying assets such as stocks, bonds, commodities, currencies, indices or interest rates.
The relationship between derivatives and the underlying assets is clearly defined so the former can effectively act like hedges against them. It is also feasible to utilise derivatives in setting up a trading strategy in which losing for one investment is mitigated by a gain in a comparable derivative.
Hedging results in lower returns compared to more volatile investments. Nevertheless, it still reduces the risk of losing your revenue. In reality, hedge funds take on the risk that people want to get rid of. By doing so, they aim to benefit from the complementary rewards.
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