Forex Hedging Similar to the stock market, investors can use forex hedging to limit the risks inherent to trading. Some people associate hedging with purchasing an insurance package for their currency position. In fact, it functions much like that. Derivatives are investment instruments that serve as a back up plan to cover potential losses. The futures contract is an example of a derivative that can be used to hedge a position. Futures contracts are binding agreements to exchange a currency for another at a set point in the future and at a price agreed upon today. Currency futures can be traded as stocks, and they serve to hedge against fluctuations in the currency exchange rates. For instance, one uses Euros to take a long position in US dollars but is concerned that the price of the dollar will drop relative to the Euro. One possibility is to opt for a futures contract on Euros using dollars. Because various factors have impact on currency prices, the price of futures contracts falls and rises too, with the contract counteracting the long position in dollars. If the dollar weakens, the price of the future contract rises and vice versa, and you have succeeded in eliminating the risk inherent to currency investment. Spot contracts are another forex hedging strategy used for the sale and delivery of spot commodities such as currencies. These have a short term date of delivery and may not be the most effective hedging instrument to use. The spot rate or spot price of a security or commodity is the price for immediate payment and delivery. Spot settlements cover a period of 1 or 2 business days starting from the trade date. The bootstrapping method is used to estimate spot prices by taking the prices of commodities or securities traded currently on the market. A spot curve is developed for all classes of securities. If you have already made up your mind to hedge, you should keep in mind that hedging comes with some costs. So, make sure that the benefits are enough to justify the costs. The goal of forex hedging is not to make profits. While costs cannot be avoided, the hedge offers some comfort. When thinking whether you should hedge, consider the fact that many investors have never used this instrument in their whole trading career. Short-term fluctuations are not events that most investors are concerned with. Hedging may be pointless in that case. For best results, you should analyze the risk, establish your level of risk tolerance, choose a forex hedging strategy, and monitor the strategy after implementing it. When you consider your risk tolerance, think about how much of the risk has to be hedged. No trade involves zero risk; so you should determine the risk you can reasonably take. Keep in mind that your forex broker may not allow for hedging within his or her platform. Research the broker fully before you begin trading. Finally, when you start implementing your hedging strategy, you have to make sure that it works as intended so that the risk is reduced as much as possible.