Forex Trading: Speculation & Hedging
Two common reasons that you would normally hear with trading and investing are: Speculation and Hedging. Often used to convey the same thing; financial trading strategies. In reality, both speculation and hedging are in reality quite different in terms of their purpose and objectives.
| Speculation | Hedging |
|---|---|---|
Objective | To make money (profit) from the rise and fall of the currency prices. | To offset or minimize (protect) any risk derived from the volatility of the price of an asset. |
Speculation in Forex Trading
Speculation is conducting a trade or market transaction that has both the potential for a substantial profit and the possibility of a severe loss. In a speculative trade like this the trader believes that the potential for gain is more than enough to offset the risk of loss.
Day-traders or sometimes referred as retail traders practice speculation in the forex market. Their primary objective is to earn a profit from the market.
Hedging in Forex Trading
Hedging is a strategy to minimize price and protect themselves risk in case of adverse movement. Or, we can say that it helps investors to reduce or even eliminate the chances of loss because of a significant movement in the underlying asset’s price. A trader needs to take opposite positions in two separate markets to execute hedging. In this way, a loss in one market could be offset by the gain in the other market.
Multinational companies practice hedging to reduce the risk of fluctuations in currency values when they buy or sell goods and services outside of their domestic market.
Speculation vs Hedging
In simple terms, speculation means to profit and hedging is to protect., Both look to achieve different objectives while participating in the forex market. It is important to note that while trading, one is not exclusive of the other. You can practice a combination of both speculation and hedging in your trading endeavor.
Why Trade Forex?
There are some risks to forex trading and the foreign exchange market, but there are also many benefits and advantages in trading the 6.6 trillion dollar market.
Pros (Advantages)
Trading Costs are kept relatively low
No clearing fees, no exchange fees, no government fees. The only fee or "charge" that traders incur for using the services of a broker is done through spread
No Fixed Trading Size
Unlike the futures market where lot or contract sizes are determined by the exchanges. In forex, you can trade smaller lot sizes.
24/5 Market
The forex market is open and operational round-the-clock, so traders can trade at their own preferred time.
No one can control the market
Unlike med-cap and small-cap stock markets, the forex market is massively liquid making it near impossible for any single entity to control or dominate the market for an extended period of time.
Leverage
Forex trading is usually leveraged. This means traders can control a larger amount of total contract value with a small margin. Leverage gives traders the ability to make higher profits (but at the same time the losses are amplified).
High liquidity, low barriers to entry, and the ubiquity of a variety of free tools on the market are also benefits of forex trading.
Cons (Disadvantages)
Volatility
All markets can show volatility at one time or another, and the forex market is no different. Forex traders hoping for short-term profits may be exposed to unexpected extreme volatility at times, which can make their currency trading strategies unprofitable.
Higher Risk
Forex markets allow much higher leverage than equities markets, meaning a leveraged trader can get wiped by small fluctuations in currency prices.
Availability
Just because the forex market is available for 24hours a day doesn’t really mean you should trade all day. The market moves differently throughout the day but there are only few periods where markets will be more volatile.
