What is Hedge? How to use Hedging strategy in trading
- 1. What is Hedge?
- 2. Learn Types of Hedging Strategies
- 3. How is Hedge applied in the financial market?
- 3.1 Foreign Exchange
- 3.2 Stock market
- 3.3 Commodity market
- 4. Hedging strategies in the foreign exchange market
- 4.1 Direct Hedge Strategy
- 4.2 Indirect Hedge Strategy
- 5. Characteristics of Hedge Hedges in the Foreign Exchange
- 5.1 Cost of Hedge Service
- 5.2 Hedge risks
- 5.3 Both parties involved in the Hedge business are at risk
- 6. Meaning of Hedging
- 7. A few notes investors need to know when using Hedge
- 8. FAQ about Hedge
- 8.1 The costs incurred in the Hedge strategy, on what factors do the relevant currency pairs depend?
- 8.2 What is a Broker in the Forex Market?
- 8.3 When using the Hedge service, how many spreads will the user incur?
- 8.4 How safe is it to use currency pairs?
“What is a Hedge” many investors mention that in recent times. How to use this strategy in trading? In the following article, BHO Network will share the knowledge about the term Hedge. We invite you to read along.
1. What is Hedge?
A hedge is a crypto term in the financial field, Hedge is an investment operation, made to eliminate or reduce risk for a specific investment portfolio.
In other words, easier to understand, Hedging is like insurance. If you buy a car, when there is a problem, it can be a financial risk, you will have to spend a lot of money to repair. Therefore, to minimize risks, you must drive carefully and obey traffic safety laws.
In addition, you must buy insurance for the car so that when the accident occurs, the insurance company will be responsible for shouldering that part of the risk for you. And this is the business of Hedging.
In financial markets, a Hedge is when you open a position opposite of an asset holding position. When the market goes against the expected direction, the central position is at risk, at this time, the hedging position is profitable, which will offset the risk for the central position.
Unlike buying auto insurance, Hedging is chosen by the investor himself or not, the level of Hedging is also determined by the Hedge strategy you decide.
2. Learn Types of Hedging Strategies
Users will use a few tools below to achieve absolute efficiency to apply effective Hedge hedging. Specifically as follows:
- Forward contract: An exchange contract between two parties to buy or sell an asset at a particular time at a specific price. This usually includes contract types such as forward contracts for commodities and currencies.
- Futures Contract: A standard contract on an exchange between two parties to buy or sell an asset at a previously agreed upon price and quantity. The instrument will include various contracts such as currency futures.
- Money market: The market where short-term buying, selling and lending occur with maturities of less than 1 year. And that will include various contracts such as covered calls on stocks, interest rate money market operations and also forex market.
There are 3 popular Hedge strategies:
- Simple Forex Hedging: You can buy and sell the same currency pair on the stock exchange. Therefore, you can profit more if you know the right time to open a position. But many exchanges do not allow you to Hedge on the same account.
- Hedging multiple currencies: Instead of hedging a currency pair directly, you can also use 2 or more different currency pairs but the same. For example, you can Hedge USD with EUR/USD and USD/CHF pairs. But this strategy is also prone to additional risks.
3. How is Hedge applied in the financial market?
Depending on the market, there will be different types of Hedge transactions for each specific asset.
3.1 Foreign Exchange
Market Major assets in the foreign exchange market are currency pairs. In this market, Hedge trading is often applied by professional traders with more trading volume, or traders of financial institutions. Because of transaction fees, Hedges in the forex market are not widely available.
3.2 Stock market
The main asset in the stock market stocks. The Hedge in this market is the option contract, of which the option contract is the more popular instrument.
These are just regular Hedge operations. Professional investors will have more advanced expertise to keep their investment portfolios safe.
3.3 Commodity market
The main assets in the commodity market are agricultural products, energy, raw materials, and metals. Therefore, this is considered a market exclusively for manufacturing enterprises, individuals and organizations that are suppliers of fuels,...
Read more: What is bear market? Determine the market status Bull market
4. Hedging strategies in the foreign exchange market
Yes 2 significant types of Hedge strategies: Direct Hedge and Indirect Hedge. Indirect Hedge has 2 subtypes: Hedge by related currency pairs and Hedge by the option contract.
4.1 Direct Hedge Strategy
The easiest direct Hedge strategy to implement, the ability to eliminate risk for the central position is very high but at the same time will also stop a lot of the potential profit of the central position a Hedge position prevents activity.
The Direct Hedge strategy involves opening long and short positions on the same asset, with supply volume and price.
The success of this strategy, will depend on the investor's judgment and decision-making ability. Because of this complexity and unpredictability, the risk of Hedge trading in the foreign exchange market is very high if the user is not experienced enough in this field.
4.2 Indirect Hedge Strategy
Hedge Strategy will include the following 2 strategies:
Hedge Strategy with Related Currency Pairs:
- This strategy is applied by choosing a currency pair with a high correlation with the current currency pair. Trade to open a hedging position. If the correlation between 2 currency pairs is unfavourable, you will open 2 same positions and vice versa.
- For this strategy, there are many costs incurred. Users must carefully consider these fees before deciding to use Hedge. If all does not affect the profit too much, you can do it and vice versa, when the loss is too high, change the plan.
Hedge strategy with options contracts:
- The strategy is applied similarly to Hedge operations in the stock market.
It can be said that, out of these three strategies, only the Hedge strategy with the relevant currency pair is always possible. Meanwhile, the other two strategies depend a lot on the policies and services of the supplier, so there will be times when it can be implemented or not.
5. Characteristics of Hedge Hedges in the Foreign Exchange
Market Hedging is also a form of investment. Instead of other investments focusing on finding profits, Hedge will minimize risks. Therefore, Hedge also has the essential characteristics of an investment trading operation.
5.1 Cost of Hedge Service
When performing any Hedge operation, the user must also pay a certain fee. That will be the amount of money users spend on derivatives. In the financial markets, creating an opposing position is also considered a new trade.
But if there is no risk, the transaction costs are negligible. This cost is only of concern when the opposite is the case.
5.2 Hedge risks
Although Hedge trades are used to Hedge investors' risks, they cannot Hedge them independently. Be it any contract, options or futures, once a Hedge trade fails, there is a risk of loss.
The investor must accept the contract terms at a low price without interference. In particular, for Hedge creating an opposing position, the risk will be higher because the difference between the expected level in the market and the price trend is very unpredictable.
5.3 Both parties involved in the Hedge business are at risk
Simply put, the insurance company will also be at risk when selling insurance to users. When activating insurance, in the case of many people at the same time, the company's costs will be more than the profits received. This can lead to a deficit, making it difficult for the company and vice versa.
It is possible to sell the options contract, the futures contract will fear the successful Hedge, the Hedge cost to the seller will be very low and not enough to cover the loss.
6. Meaning of Hedging
Has brought investors certain advantages. This is considered a barrier to protecting and preventing risks in making investment decisions for many people. The essential meanings of Hedging in the stock market are:
- Has the effect of stabilizing cash flow
- Also to determine the selling or buying price of goods or security
- Reducing potential risks
- Reducing transaction costs trading
In the futures market, investors can Hedge risks and seek profits for themselves with this Hedge technique.
This hedging trade will often be the opposite of speculative trading. Hedgers are not trying to “win” and make money on movements in actual prices.
Read more: What is Meme Coin? Everything you need to know about Meme Coin
7. A few notes investors need to know when using Hedge
After understanding what a Hedge is, investors need to know more about some notes to avoid risks to make transactions more effective.
To avoid unnecessary troubles, investors need to understand this investment method thoroughly. The reason is that not all exchanges allow the use of this service.
The simultaneous use of 2 orders at the same time means that the investor has to bear 2 fees at the same time. Therefore, it is necessary to consider the issue of transaction fees when using.
To minimize risks, investors should prioritize using currency pairs with low volatility.
Traders' market predictions sometimes go wrong as the probability of inversely correlated forex pairs cannot be 100% absolute.
When choosing a maintain order, if an investor does not have the determination and insight, it is easy to lose the opportunity to earn huge profits.
8. FAQ about Hedge
Although they understand what a Hedge is, many people are still confused. BHO Network will summarize the questions that are most interesting to many people. Let's follow along.
8.1 The costs incurred in the Hedge strategy, on what factors do the relevant currency pairs depend?
Four main factors affect the cost of a strategy: The spread, the pip spread, the spread, and the swap.
8.2 What is a Broker in the Forex Market?
A broker can be understood as a 3rd party intermediary that has the function of linking small investors and large suppliers, users can work through the broker to trade.
8.3 When using the Hedge service, how many spreads will the user incur?
When using Hedge, the user executes 2 orders at the same time, so there will be 2 fees as the spread.
8.4 How safe is it to use currency pairs?
Users should choose less volatile currency pairs to minimize risk.
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Above is the information about What is Hedge that BHO Network has shared. Hope that you have gained more practical knowledge about the concept, meaning, and the market in which Hedging is commonly applied. Follow our website for more updates.
Published on January 19, 2022
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