Introduction
Hedging is an investment strategy used by traders to reduce their risk exposure in a volatile market. It involves taking positions in derivatives that offset the potential losses from a given investment, such as stocks and currencies. One of the most popular hedging strategies is hedging with futures, which involves taking both a long and short position in the same commodity or currency in order to mitigate losses from one of the trades. In this article, we will look at how to use hedging with futures to reduce risk in the foreign exchange market.
What is Hedging with Futures?
Hedging with futures involves taking both a long and short position in the same currency pair at the same time. The long position is taken to benefit from the potential upwards movement in the exchange rate of the currency pair while the short position is taken to profit from any potential downward movement. By taking both a long and a short position, the risks associated with any single position are reduced and any gains or losses on the trades are therefore limited.
The Benefits of Hedging with Futures
The primary benefit of using hedging with futures is that it reduces the risk of losses associated with any single position taken in the market. As there is no market risk associated with futures contracts, traders are guaranteed to receive the exact amount of money that is initially invested - regardless of the performance of the underlying asset.
This provides traders with greater peace of mind as the danger of suffering large losses is significantly reduced. Additionally, trading with futures contracts can help traders to take advantage of short-term price movements in the foreign exchange market without having to maintain a large degree of capital.
How to Trade Hedging with Futures
Trading with hedging with futures is relatively straightforward and can be done through most online brokers. Traders must first decide which currency pair they wish to trade, which will require picking two currencies that they expect to have a degree of volatility against each other.
Once this has been established, traders must then open a long and a short position in the chosen currency pair. This involves either buying a futures contract or holding a position in the cash market, depending on their preference. Traders then need to maintain and manage their positions according to the direction of market movements - closing out positions or adding to them as necessary.
Conclusion
Hedging with futures is a popular approach to reducing risk in the foreign exchange market. By taking long and short positions in the same currency, traders can mitigate against potential losses sustained from either position and take advantage of short-term price movements. The main benefit of this strategy is that it provides traders with greater peace of mind as the risk of losses is reduced significantly.
