When we invest in the markets we leave ourselves exposed until the investment moves into profit. We have already talked about locking in profits using your stop loss in my previous post.
In this post I will let you know how you can attempt to limit your exposure by “hedging” in a couple of simple ways, to try and counter your initial exposure with hedged investments. Diversification of your portfolio can be the key to reducing your liabilities.
Hedging is not an exact science however; there are some patterns that constantly reoccur in the markets on a more regular basis.
How can you hedge your exposure?
Exposure in a currency pair, for example (long) EUR/USD
- Take a different pair that includes the base currency of the exposed pair (long EUR) and do the opposite.
- For example you could (short) EUR/JPY, if the EUR does not appear to be performing against the JPY.
The point is that the EUR could be performing well against the USD however, it may not be performing well against other currencies.
Exposure in a stock or Indices for example (long AAPL).
When investors buy foreign stocks, they’re also effectively buying the foreign currency that the stock is denominated in. So a foreign stock’s return is really a combination of two things: the performance of the stock and the performance of the country’s currency. This correlation can be used to try to hedge a position.
For example, a UK investor invests in a US stock. After a period of time the value of the stock rises 7% however, in the same period of time the GBP falls 11% against the USD. As a U.K. investor, you’ve potentially lost money on that investment, until the currency turns around, because although the stock price has risen, the currency value has fallen. To Hedge, the investor could take a Short GBP/USD (Hedge) position in the currency to cover the depreciation of the exchange.
Relationships between currencies & commodities
CAD is strongly related to oil prices because its biggest export to the USA is oil, when oil is traded it puts demand on the CAD and generally pushes the price of the currency up.
In the same way, the AUD is related to Gold: Australia is a major producer of Gold and its currency’s performance can be related to the price/demand for Gold.
These relationships can help investors use hedge positions to counter initial investments.
In simple terms Hedging is a matter of “not having all your eggs in one basket” . The investor is simply looking at ways of diversifying the risk of the initial investment.