Many strategies are utilized in forex marketing to minimize risk and maximize profits, one of the most useful of which is hedging. Foreign exchange hedging is similar the stock market, as the strategy acts somewhat as an insurance policy for an investment. The basis of the strategy involves using investment instruments called forex derivatives, which basically provide a backup plan for the trader in the event of any losses. This strategy removes a lot of the stress associated with speculation because it limits losses and provides a secondary plan of action in the event of a trade gone wrong. The following information outlines the basics of this strategy and its variations.
Understanding Forex Derivatives
A derivative is a financial agreement that is valued based on the price of a certain asset, rate, index, commodity, or event. The term derivative was coined because the value of derivative agreements are 'derived' from the significance of one of the aforementioned factors. There are various types of derivatives, the most common of which include futures, forwards, swaps and options. Most of the time they are used to enhance the security and minimize the risk of a particular trade or agreement. Thus, derivatives play an integral role in the process of foreign exchange hedging. Learning the purpose of each one and how to utilize them in appropriate situations is imperative for the aspiring professional dealer.
Using Forex Futures
Some traders use derivatives known as futures to hedge a position. In a future contract, the dealer agrees to conduct a currency exchange on a specified date at the price that was active on the last closing date. Forex futures are bought and sold in the market similar to any other investment instrument, and are an ideal way to hedge a position and minimize the impact of currency exchange rate fluctuations.
The following is a prime example of how futures are used to hedge a position: A dealer uses USD to take a long position in EUR, but is concerned that the price of EUR fall in relation to USD, so they take out a futures contract on USD using EUR. As other factors continue to affect the price of currencies, the prices of futures also fluctuate, letting the contract counteract the long position in EUR. Thus, if the EUR weakens, the price of the contract rises, but if it strengthens, the price falls. This simple strategy is an effective way to eliminate risk from nearly all investments.
What is Forex Arbitrage?
Forex arbitrage is another method used to minimize investment risks, by finding a currency pair that is priced wrong, and then buying/selling it against a different pair to maximize the total difference, thereby exploiting the inefficiency of the pairs. Although these types of opportunities are ephemeral due to the self-correcting nature of market, they do exist and are often capitalized on by experienced traders. In the arbitrage strategy, traders compare the prices of pairs that contain a specific currency, in an effort to find a situation that would be profitable. Arbitrage calculators are used to find the most beneficial trades, and many of these calculators can be found for free online.
To use the arbitrage strategy, a trader would need accounts with multiple brokers in different areas of the world. It is advisable to test the strategy in a demo account before progressing to live trades. Most of the time a arbitrage trade requires using 2 or 3 different pairs to earn a profit. Forex arbitrage is a somewhat advanced strategy that requires persistence and patience, and is not recommended for the novice dealer.
The above information provides basic insight into the overall strategy of hedging and arbitrage, both of which are advanced tactics that accumulatively generate millions of dollars for traders around world on a daily basis. As arbitrage is the more complex of the two concepts, it is recommended that one learns how to hedge positions before progressing to using arbitrage calculators and opening several accounts around the world.