Risk management is an essential component of businesses and in recent times, it has become embedded in all operational and non-operational areas as uncertainties levels become high. High uncertainty levels in global trade, cyber fraud and geopolitics have awakened risk managers to improve their risk management tools hence hedging.
Stock, Currency and Commodity traders are exposed to volatility risks as these unpredictable markets remain controlled by supply and demand factors. External factors such as geopolitics also influence the performance of commodities. The currency market for instance records significant movements in an intraday session trading due to macroeconomic decisions by central banks, policies and political statements by key players in the global economy. A trader’s risk management tool in managing volatility risk is the hedging tool.
A trader’s objective is to buy an asset (stock, currency, commodity) at a lower price and sell this asset later in its life when prices rise. During the period until which the trader sells the asset, there is an exposure
What is back-to-back trading?
A back-to-back trading strategy requires that a trader takes a reverse position immediately to close an exposure. However, it does not matter which position the trader begins trading (begin with a buy and sell later or sell first and buy later).
For instance, a currency trader in Ghana buys $1,000 at a rate of GHS5.6 but this risk-averse trader sells the $1,000 to his client immediately, a businessman who imports goods from China instead of holding onto his position until the value of the US Dollar goes up. This trader is comfortable with small profits gained from margins.
Back-to-Back Trading Illustration of Hedging
| Buy (Long position) 9:30:05 AM|
USD1,000 @ 5.6
| Sell (Short position) |
USD1,firstname.lastname@example.org i.e. 5.6 plus margin
The supply and demand of commodities depend on factors such as weather (Agriculture commodities), geopolitics (Crude Oil), etc. and for these reasons, buyers and sellers have to be protected against market movements. The futures market was established to help manage these price and supply risks. In futures trading, buyers are allowed to conclude on prices for future deliveries today. Trading on a futures market requires that the market participant holds an account with the exchange which is responsible for the specific commodity.
Due to the liquidity requirements of operating a futures account and the need to be highly knowledgeable in the commodity being traded are important. Most people transfer the management of a futures account and trading to brokers, usually banks and financial institutions.
Currencies can also be hedged as commodities using forward currency rates. In currency transactions, an importer who wishes to import goods in the future can fix exchange rates with the lenders or banks to prevent the effect of currency fluctuation on their business. Forward currencies can either be traded at discounts or premiums depending on the economic outlook of the underlining economy.
Futures Trading Illustration of Hedging
|Buy (Long position)- Today |
An importer of goods bought the US dollar at 5.7 from the bank in anticipation of importing goods in the next 7 months.
The importer would not know the value of the dollar in the future but is aware that the currency market is volatile.
| Sell (Short position) – 7 months|
The importer decides to import goods now but the dollar
appreciated to 5.9 but the hedging strategy of buying currency
forward will protect the importer against uncertainties of the market.
The strategies of hedging are any and hence options will be discussed in the next publication. Kindly subscribe to catch the next publication.
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Written by Kwaku Kofigah