Hedging is a specialized risk management strategy in financial markets that allows traders to protect themselves against unfavorable market fluctuations by opening opposing positions.
Hedging involves opening a new trade position to offset the risk of an existing position. For example, if a trader holds a long position on the EUR/USD currency pair and is concerned about a price decline, they can open a short position on the same pair to reduce potential downside risk.
Direct Hedging
In this method, a trader opens two opposing positions (buy and sell) simultaneously on the same asset. This strategy is commonly used to protect unrealized profits or minimize potential losses.
Cross Hedging
In cross hedging, a trader opens opposing positions on correlated or related assets. For instance, if a trader holds a long position on EUR/USD, they can open a short position on GBP/USD for hedging purposes, as these two currency pairs are typically correlated.
Hedging Using Derivative Instruments
Hedging with futures contracts or options is also common. These tools allow traders to manage risks associated with the underlying asset prices effectively.
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