What is Hedging and How Does It Work?
They say life happens when you’re making plans.
And more often than not, life tends to throw negative events our way. While we can’t prevent negative things from happening, we can insure ourselves against the adverse effects on our finances by hedging. This has got nothing to do with landscaping, by the way.
So What is Hedging then?
Hedging is a form of insurance. You have most likely heard the phrase “hedging your bets”.When we decide to hedge, we insure ourselves against the impact of a negative event on our finances. If we’re properly hedged when unforeseen circumstances rain on our parade, the impact of the event is reduced. Hedging, whether in your portfolio, business personal life is about decreasing or transferring risk.
It has been used as a verb since the 16th century, meaning “equivocate; avoid commitment” and when building a hedge around a property made the property more secure. It entered into the world of financial transactions when a loan was secured by including it in a larger loan, “hedging one’s debts”.
Hedging and You Didn’t Know It?
Most of us are engaged in hedging in some way in our daily lives. When you buy life or medical insurance to support your family in the case of your death or an accident/injury, this is a hedge. With homeowner’s insurance, we are hedging ourselves against break-ins, fires and other unforeseen occurrences. Hedging is a key strategy that can help us protect our homes, cars, businesses and portfolios from uncertainty.
We pay monthly sums to insurance companies for the coverage that they provide in the areas of household, medical and life insurance. While the textbook definition of hedging is an investment taken out to limit the risk of another investment, insurance is a prime example of a ‘real-world’ hedge.
Hedging with Forex
When it comes to hedging with forex:
- It is a strategy used to protect your position in a currency pair (explain here what a currency pair is please)from an adverse move.
- It is a form of short-term protection when a trader is concerned about news or an event triggering volatility in currency markets.
- There are two related strategies when talking about hedging forex pairs in this way.
- One strategy is to place a hedge by taking the opposite position in the same currency pair e.g if the investor holds EUR/USD long, they short the same amount of EUR/USD.
- The second strategy is to buy forex options if the investor is holding a long position in a currency.
How We Use Hedging at Algo
Within the forex market, you may predict that one position will go a specific way. The biggest challenge, however, is that it can take much longer to go your way than you thought. Which leaves you in a minus position (also known as a drawdown).
At Algo, our hedging strategies are based on:
- Minimising the drawdown.
- While simultaneously making money and opening up smaller positions in the opposite direction to what we initially planned.
- So we make money even when it goes against us,
And we make most of the money once it finally turns and goes our way.